If any business has given tech investors chills over the years, it's memory chips. In this commodity business, having a good brand has little effect on your pricing power. And if overcapacity leads to a pricing crunch, a memory maker's bottom line will get ugly in a hurry. This has been equally true for DRAM giants such as Micron Technology (NYSE: MU ) and NAND flash memory titans such as SanDisk (Nasdaq: SNDK ) .
But there's also a corollary involved here: When times are good for memory manufacturers, thanks to strong demand and controlled supply, their sales and profits can take off in a hurry, and carry their stock prices with them. This happened with SanDisk in 1999, 2003, and 2005. And while it's too early to count on SanDisk's shares taking off in 2010 they way they did in those years -- especially since they were aided by bull markets -- the groundwork for a good year looks like it's in place.
Smartphones and solid-state drives galore
Each of SanDisk's past run-ups was propelled by a boom in one or more markets whose products need huge servings of flash memory to work. In 1999, the digital camera market drove the company. In 2003, the sudden proliferation of USB flash drives joined with digital cameras for another boost. And in 2005, the focus shifted to a combination of flash drives and MP3 players, whose flash usage took off in the wake of Apple's (Nasdaq: AAPL ) release of the iPod Shuffle and Nano.
Looking at 2010, it's easy to see how smartphones could be a major driver for the company. IDC expects smartphone shipments to grow by 20% next year, as Apple and Research In Motion (Nasdaq: RIMM ) continue to gain handset market share, and a huge wave of devices running Google's (Nasdaq: GOOG ) Android operating system hit the market. And the amount of flash memory that ships with these devices should continue to grow, as consumers look for more and more space to store their music, videos, pictures, and apps.
Apple has made a point of doubling the storage capacity of the iPhone with each new generation of the device -- the highest-capacity version of the 3GS ships with 32 gigabytes of storage. Motorola (NYSE: MOT ) , for its part, ships the Droid with a 16GB memory card. And Nokia packs 32GB of capacity into its N900 phone. With competition in the smartphone space only intensifying, you can count on manufacturers staying aggressive on the storage front.
If smartphones represent a continuing growth story for flash memory, then solid-state drives (SSDs) represent the next big thing. With their superior performance, reliability, and power consumption, you can count on SSDs steadily taking share from conventional hard drives in the PC, workstation, and server markets. With hard drives maintaining a decent cost advantage, the transition is bound to take many years, but we're already seeing SSDs find their way into everything from netbooks, to high-end desktops and notebooks, to servers running high-performance databases.
What especially makes flash manufacturers' mouths water about the SSD market is the massive capacity numbers involved. While big-name smartphones currently top out at 32GB, SSDs with 64-128GB of capacity have seen decent sales. And since their competition is hard drives from the likes of Seagate (NYSE: STX ) featuring up to 2TB of capacity, demand for bigger drives is bound to grow as prices decline.
Capex remains low ... and so does the valuation
While demand should continue to boom, supply seems unlikely to run out of control. The massive collapse that flash prices saw in 2008 seems to have been a wake-up call for the industry, and it has led to both a dramatic decline in capital expenditures over the last 18 months and a guarded approach to future spending increases.
Thus, while research firm IC Insights estimates 83% bit growth this year in NAND demand, Gartner and IDC have both predicted bit supply increases of less than 50%. And though capex is bound to increase in 2010 from 2009's depressed levels, research and pricing data firm DRAMeXchange still sees demand growth (81%) slightly exceeding supply growth (79%) next year, with a small amount of oversupply in the first half of the year being offset by a shortage in the second half. If those figures prove reasonably accurate, we should see a healthy pricing environment at a time when demand is still soaring. And that should spell strong revenue and profit growth for NAND manufacturers.
And SanDisk, in particular, might have a chance to outgrow the broader industry. The company's recent decision to start selling the memory chips it manufacturers for use in third-party memory cards -- rather than merely using them for SanDisk's own, branded products -- has been a runaway success, and it was a major reason why SanDisk blew past the market's revenue and earnings estimates during its October earnings report. There's still room for SanDisk to gain additional share in the third-party card market from more established manufacturers such as Samsung.
In addition, SanDisk recently began manufacturing chips using its X4 technology. By packing four bits of information per memory cell, compared with the two bits per cell featured in most flash memory today, X4 should give SanDisk a capacity and pricing edge in the memory card markets that it plans to target with the technology.
But while SanDisk has the potential to be a decent growth story in 2010, it sure isn't priced like one. With roughly $3.2 billion in net cash, the company's enterprise value stands at less than eight times its estimated 2009 and 2010 earnings. And those 2010 estimates look pretty conservative if pricing stays healthy. Yet again, the market's historical caution toward memory manufacturers might present a compelling buying opportunity.
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