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Should SanDisk Shareholders Be Worried About This Trend?

By Sean Williams - Updated Apr 6, 2017 at 10:16PM

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Falling margins and rising R&D could take their toll.

SanDisk (Nasdaq: SNDK), the king of everything flash memory, attempted to yet again dazzle the market with earnings after the bell on Thursday -- only this time, the stock didn't pop as it has in the past.

The maker of NAND flash memory -- a type of fast access memory that's great for mobile data storage -- is seeing booming end markets as not only smartphones gain continuing adoption, but other areas such as tablets gain traction as well. However, despite flash-memory tailwinds from sources such as Apple's (Nasdaq: AAPL) bullish results -- and it's worth noting that Apple has been known to use Samsung and Toshiba predominantly -- and a 19% year-over-year jump in revenue, one key metric catches my eye as a threat to SanDisk's continuing rally: margins!

GAAP Figures

Q1 2011

Q4 2010

Q3 2010

Gross product profit margin

38.60%

39.50%

47.70%

Operating margin

27.00%

26.90%

35.00%

Source: Company filings.

SanDisk's margins have taken a nosedive in the most recent quarters as competitive pricing pressure, higher input costs, and increased research-and-development expenses have eaten into its bottom line. As you can see, in just two quarters, SanDisk has shed 800 basis points of operating margin -- yet its stock has responded by moving 32% higher over the past six months. Feel free to explain that, but don't hurt yourself trying.

What shareholders have to realize is that when you purchase a company like SanDisk, you're buying into a commoditized space. Although you can't physically trade flash-memory futures or anything of the sort, an oversupply or undersupply of flash products can significantly move flash-memory prices -- which, in turn, can drastically alter SanDisk's bottom-line results. In essence, SanDisk's earnings capacity is really capped by consumers' willingness to spend, and unfortunately, that willingness to spend is not going up as fast as the cost of fuel at the moment.

Even my personal darling in the memory-chip sector, Integrated Silicon Solution (Nasdaq: ISSI), can muster only a forward P/E of 6.5, thanks in part to the entire sector's inability to control the pricing of its product. Exterior forces (i.e., consumers) control how these products are priced, and that situation makes outlooks very difficult to predict and margins very erratic.

Based on what I saw from SanDisk last week, I'd say it's nearing rarefied territory, trading at a double-digit multiple for a stock with plummeting margins. In its defense, the company is ripe with cash and did generate $121 million in free cash flow during the quarter, and its cash flow from operations soared relative to a year ago. Still, with margins falling as dramatically as they've been, I'd have to think the company is going to have to deliver for shareholders pretty soon. Otherwise, we may have seen yet another peak in the flash-memory cycle.

What’s your take? Does SanDisk still have its flash, or will higher margins soon become a distant memory? Consider tracking Sean's prediction by adding SanDisk and your own personalized portfolio of stocks to My Watchlist.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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