Updated from 3:29 p.m. EDTSanDisk's ( SNDK) arsenal of flash memory assets looks more formidable than ever following Monday's announcement of its plans to acquire MSystems ( FLSH) for $1.35 billion. The deal strengthens SanDisk's position in two key markets for flash memory chips, provides it with significant intellectual property and gives it a promising technology that could dictate the future of flash -- all for what some analysts and investors consider a bargain. The all-stock transaction values each share of MSystems at 0.76 of a share of SanDisk common stock, about a 13% premium from the price at Friday's close of market. "Given that the premium is so meager, I'm wondering if MSystems is going to report a pretty ugly quarter on Monday," says Seligman Technology analyst Sangeeth Peruri. Analysts expect MSystems to post a profit of 22 cents a share on $206 million in revenue for the second quarter. Shares of the Israeli company have been under pressure of in recent months, as MSystems announced it would restate five years of previous financial reports as a result of an internal investigation into its stock-option accounting and pulled the plug on a secondary stock offering. Shares of MSystems surged more than 13%, or $4.21, to $36 on the news, while investors bid down SanDisk shares by 48 cents, or 1%, to $46.66. But Peruri and others say the marriage makes a lot of strategic sense for SanDisk. MSystems had $415 million in sales of USB flash drives in 2005, which will provide a nice bump to SanDisk's USB drive business. Perhaps even more significant is the fit between the two companies when it comes to cell phones, which many consider the most important market for flash chips in the near term. As cell phones take on increased functionality, flash memory, which stores data even when the power is switched off, is expected to play a larger role in the handsets.
SanDisk makes a variety of removable flash cards, which can be inserted into a cell phone to provide storage for things like pictures and music. MSystems sells flash cards that fit into the SIM card slot that's already present in many cell phones. MSystems also has an embedded flash technology targeted for cell phones, known as mDOC, which combines the best attributes of two different flavors of flash memory: NOR and NAND. CIBC World Markets semiconductor analyst Daniel Gelbtuch estimates that the market for embedded flash in cell phones was roughly 40 million units last year, out of a total cell phone-handset market of 800 million units. But he believes embedded flash will grow rapidly in the next several years, representing an increasingly large share of the market for cell phone flash chips. The combination of the two companies' cell phone products means that SanDisk now has a "virtual lock" on the handset market, says Gelbtuch, who upgraded his rating on SanDisk following the acquisition announcement. CIBC makes a market in shares of SanDisk and M-Systems and expects to receive or seek compensation from SanDisk in the next three months for investment banking services. The deal comes a month after Micron ( MU) completed its acquisition of Lexar Media, another flash memory company. Like the Lexar deal, Monday's acquisition of MSystems illustrates the challenges of surviving in the flash market without strong manufacturing operations. Going fabless, or outsourcing the actual manufacturing of chips to a third party, is an increasingly popular business model in the semiconductor industry. But in the commodity flash market, there's still no substitute for having a dedicated supply of silicon. "
MSystems CEO Dov Moran was probably losing sleep every night about where he was going to get his next source of supply," says CIBC's Gelbtuch. "Now he can get some sleep at night." MSystems was fond of touting its so-called virtual fab model, by which the company bartered its intellectual property to manufacturers in exchange for capacity at their plants. That model showed signs of stress lately, however, such as in April, when MSystems abruptly cancelled its relationship with Samsung, claiming that Samsung was not meeting the terms of the deal.
With Lexar selling and MSystems selling, I think it's fairly obvious that that's a very difficult model," says Seligman Technology's Peruri. Sandisk has a joint venture with Toshiba, the creator of flash memory, under which the two manufacture flash chips together and share the output. Monday's acquisition also represents the latest move by SanDisk to collect firms that are developing next-generation versions of flash memory. In November 2005, SanDisk acquired Matrix Semiconductor, which has technology with the potential to vastly increase the amount of data that can be stored on a flash chip. MSystems has its own
next-generation flash technology , dubbed x4, which promises to double the amount of storage per cell and thus lower production costs. "SanDisk believes that the only way to continue to have the kind of growth in the NAND market that they have enjoyed in past is to continue to force consumer prices down at a very fast rate," says Jim Handy, a flash memory analyst at market research firm Semico. With x4 and the Matrix technology, SanDisk is positioning itself to undercut competitors' prices by being at the leading edge of flash innovation. Of course, the x4 technology is still not in volume production, which means its real-world benefit is still not proven. "You never know what the obstacles are until you get into mass production," says Handy. "And since it is not in mass production, there ain't no telling."