Investors focused on the worst last week after seeing SanDisk's (NASDAQ:SNDK) 2003 earnings. The manufacturer of flash memory storage products posted annual net income growth of 369%. Still, shares have dropped more than 16% since last Wednesday's close.

What gives?

SanDisk's warning about shrinking product gross margins spooked the market. Management predicted that margins will come down from 36.4% in the fourth quarter, to between 32% and 36% for the first half of 2004. For the second half of the year, margins will shrink to between 28% and 32%. The company also forecast a 40% drop in its prices.

So, is SanDisk as overvalued, given its margin outlook, as investors appear to believe?

SanDisk registered a 6.6% net margin during 2002. That jumped nine points during 2003, to 15.6%. With product gross margins falling, it doesn't seem likely that the company will continue to earn $0.15 for every dollar of sales. Or does it?

Product gross margins don't include royalty revenue. SanDisk has one of the richest royalty streams in all of tech, booking $36 million from its intellectual property during the fourth quarter. Royalty revenue more than doubled from 2002 to 2003, and management believes at least another 20% gain during 2004 is possible.

That's huge news, because revenue from intellectual property is pure profit. Historically, it has added five or six points to total gross margin, meaning SanDisk could produce a 38% gross margin for 2004, including royalty revenue. (Total gross margin for 2003 was 41%.)

If the three-point drop also hits the bottom line, then SanDisk would earn $0.12 for every dollar of sales this year. Using the company's predictions of between $1.5 billion and $1.75 billion in revenue, that would put profits between $180 million and $210 million, which roughly translates into $1.89 to $2.21 per diluted share. SanDisk earned $2.03 per diluted share during 2003. Could that be right? A best-case scenario of 9% earnings growth?

Part of the problem is that SanDisk's share count ballooned with a secondary offering of 8.3 million shares in September. Plus, 8 million more shares could come into the market in November after $150 million in callable notes get converted.

The expected dilution makes SanDisk look fairly valued now. But when you consider the growth of the flash card market -- which is expected to triple by 2007 -- SanDisk doesn't figure to just suddenly hit the brakes on earnings growth.

In fact, the prospects for SanDisk are huge. If royalty revenue continues to accelerate, sales volume increases, and the market grows as expected, then the company has all the markings of a classic Rule Breaker.

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Tim Beyers doesn't own shares of any of the companies mentioned.