The third quarter is historically a strong period for SanDisk (UNKNOWN:SNDK.DL), but management guided for revenue of just $1.675 billion-$1.725 billion, representing 4.6% growth at the midpoint. Analysts had been expecting revenue of $1.74 billion. Additionally, management guided for gross margin to come in between 47%-49%, below last year's gross margin of 49.3%.
Should investors be concerned about SanDisk's weak outlook?
What's behind that gross margin?
The pressure on gross margin is coming from additional sales of custom embedded solutions, such as those found in the Apple (NASDAQ:AAPL) iPhone. This was nothing unexpected, as management noted in its first-quarter earnings release that it expects the product mix to shift more toward embedded products in the second quarter. Management expects that shift to continue into the third quarter, with strong sequential growth in sales of both custom embedded solutions and iNAND products.
The increasing demand of SanDisks' embedded products is great, except that SanDisk has become supply constrained. As such, management must make strategic decisions on which orders it fulfills. SanDisk is always going to take an order from Apple.
Apple is an extremely valuable customer for SanDisk, accounting for 20% of the company's revenue in 2013. As Apple accounts for more of SanDisk's total revenue, however, it also has the ability to exert pricing power. Apple has done this with several key suppliers before, and SanDisk is no exception. Therefore, revenue and gross margin at SanDisk get hurt.
Solving the constraint problem
The biggest reason for SanDisk's supply constraint is that it has tried to exercise cost control, limiting its wafer capacity expansion to just 5% this year. Overall, CEO Sanjay Mehrotra expects SanDisk's bit supply to increase on the low end of the company's previously stated range of 25%-35% in 2014. Meanwhile, the company estimates the industry bit supply will grow 40% this year.
CFO Judy Bruner reassured investors on the conference call that SanDisk expects to grow its bit supply in line with the industry next year -- 30%-40%. She also noted that part of the supply constraint was due to stronger-than-expected demand for SanDisk's 19nm node versus its newer 1Y node. As a result, management slowed the transition to 1Y. That's not entirely bad, though, as longer product cycles typically lead to more stable pricing.
Still part of a long-term growth market
What long-term investors need to remember at times like this is that SanDisk is still a leader in the SSD market. In the long run, SanDisk's product mix will almost certainly shift more toward high-margin enterprise SSD products. IDC expects the enterprise SSD market to grow to $7 billion by 2017, up from $3 billion in 2013.
Moreover, management expects to continue expanding its share of the SSD market. Last month, the company agreed to purchase Fusion-io for $1.1 billion. The acquisition strengthens its position in enterprise PCIe hardware and software solutions, whereas SanDisk previously focused on SATA and SaaS products. Fusion-io provides a set of big clients for SanDisk to address, while SanDisk will be able to grow Fusion-io's business more rapidly with its deeper pockets.
SanDisk is focused on providing a vertically integrated solution -- hardware and software -- for enterprises, which Mehrotra believes will be key to winning share. Fusion-io adds excellent software to SanDisk's portfolio.
As SanDisk expands its capacity, it should be able to shift its product mix toward the increasing demand of enterprise SSDs. When that happens, revenue and margins will go back up.
A buying opportunity?
After the market sold off shares 13.5% on Thursday, long-term investors may be wondering if the sell off represents a buying opportunity. SanDisk's stock is still valued quite highly, with a trailing P/E ratio of 19.4 compared to its peers in the mid-to-low teens. It's also priced high in terms of sales (3.4 times) and free cash flow (16 times). Although it has strong potential to grow faster than the rest of the industry, there are other options that offer better value. Still, investors who got in earlier shouldn't be scared off by management's weak short-term guidance.
Adam Levy owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.