Digital film vendor

Lexar

(LEXR)

could be headed for trouble.

Insiders have been on a tear to dump shares in the company, whichsells the kind of tricked-up film used to record the pictures in digitalcameras.

Lexar, which sells to big retail stores, basically takes a bullet forits customers if prices get out of whack by promising to protect customersif the value of its products declines after they've been sold. But that canbe a painful proposition for investors: In the past it's caused Lexar'smargins to plunge into the red.

A squeeze could be coming again.

To understand the potential trouble, first consider how Lexar makes itsmoney. The company draws most of its revenue -- 86% of sales in the secondquarter -- from selling digital film. But unlike its competitors, it's toosmall to make flash memory, the primary component in digital film, on itsown. So it buys flash from

Samsung

, tacks on a proprietary form ofsilicon known as controllers, and then sells the finished version to storeslike

CompUSA

and

Wal-Mart

(WMT) - Get Report

.

The trouble is, it's standard industry practice for digital filmvendors to offer their customers, the retail stores, something known as"price protection."

A store like Wal-Mart doesn't want to be left holding the bag if itsinventory of digital film suddenly drops in value -- which would most likelyhappen if there's a surge in supply. So to entice Wal-Mart to buy fromit, Lexar might cut a deal. Say Wal-Mart buys film from the company, butLexar later decides to drop its film prices in order to stay competitive.In that case, Lexar will pay back Wal-Mart some of the difference.

Everything's fine, as long as prices don't oscillate too wildly. Butthis being semiconductors, they do.

In 2001, a glut of supply forced prices of NAND flash, the type of memory used in digital cameras, down 61%. In thememorably disastrous first quarter, Lexar saw its gross margins dip 37%into the red as it shelled out over $5 million for price protection,rebates and returns. By comparison, revenue in the same quarter only reached$16 million.

Price-War Casualty

Could this worst-case scenario happen again? Maybe not on the samescale, but short-sellers point to worrying signs -- namely, the potentialfor an oversupply of flash to develop later in the year, which would forcedown prices.

Toshiba recently slashed its flash memory prices 10% to 20% belowthe competition in a bid to grab market share, said Jim Cantore, principalanalyst for memory at iSuppli, a market research firm. "They're veryaggressive at trying to attract new business. I think going into the fourthquarter there's probably greater potential for more of a price-warsituation."

Meanwhile, Samsung said over the summer that it plans to bring a lotmore flash capacity online late this year as it converts two DRAMfabs over to production of NAND."My gut feel is if they were to run at full capacity, it would be enough tosatisfy the entire market for NAND," says Semico Research analyst JimHandy. Even assuming one of the fabs needs to be modernized, he thinksSamsung still might be able to satisfy some 70% of the flash market.

Handy says he wouldn't be surprised if Samsung also sold flash atprices below cost, since it's done the same thing in the past with DRAM.

Lexar itself has acknowledged the increased capacity of flash willaffect it. In a shelf registration filed Sept. 26, the company says:"We anticipate that our average selling prices will decline as additionalflash memory capacity becomes available in late 2002."

If that scenario comes true -- Samsung floods the market with NANDflash and the price of film tanks -- Lexar stands to get hurt worse thanits competitors. (Remember, if prices drop dramatically, Lexar may have tocover price protection costs for some of its customers.)

To be sure, Lexar's bigger rival

SanDisk

(SNDK)

offers some of the samedeals.

But unlike SanDisk, Lexar buys its supply of flash memory from a thirdparty, Samsung. If the price of flash declines, it's not a given thatSamsung will pass on the full benefits to Lexar.

In contrast, SanDisk and other rivals

Hitachi

and

Toshiba

manufacturetheir own flash memory. Since they're essentially buying from themselves,they'll reap the full benefits of any price declines.

Lexar maintains that a drop in the price of flash wouldn't make muchdifference in its gross margins. "I think it's a positive for us if Samsunglowers their selling prices, because our purchase price from them is lower,so our cost structure goes down," says Lexar CFO Michael Perez.

But in a filing with the

SEC

last week, Lexar suggested otherwise,acknowledging that its business model can be a disadvantage. In itsprospectus for a shelf offering, the company says, "Because flash memoryrepresents a significant portion of the cost of digital film, SanDisk mayhave a competitive advantage in that it will have access to high-capacityflash memory at prices that may be substantially below the prices thatSamsung will charge."

Perez denies the company is worried about the potential for oversupplyof flash later this year. "Right now, we don't think it's a potentialissue," he says. "We think there's sufficient demand in the market."

Currently, the company's assuming no big changes on the flash supplyfront. Perez says 2002 revenue guidance of $140 million or betterreflects "a relatively stable economic environment -- 8% to 10% per quarterprice declines, which we think is normal. We haven't factored in anabnormal price decline."

To be sure, not everyone thinks Lexar's facing a lot of trouble. Sincea management shuffle and the appointment of a new CEO, "the company hassubsequently evolved into an encouraging turnaround story," writes J.P.Morgan analyst Paul Coster in a note. He points out the company has postedsequential revenue growth over the last six quarters, steady gross marginsabove the 25% level, reduced operating expenses, and operatingprofitability for the past two quarters. (J.P. Morgan is an agent for Lexar in connection with its shelfregistration.)

Analysts also say that Lexar's agreement with Samsung, which will ensure ita steady flash supply, will make it easier to keep inventories low. Thatagreement was not in place during the terrible first quarter of last year.

But others are far more pessimistic about Lexar's prospects. Ajay Patel, afund manager with Clear Lake Partners, has a short position in the stock.Though he says competitor SanDisk would also likely get hurt in the eventof a flash glut, Lexar would suffer most. "We focus on the weakest animalof the herd," he said.

Consider the two companies' respective balance sheets. In its mostrecent quarter, SanDisk claimed cash and short-term investments of justunder $400 million, while Lexar had a mere $31 million. Also, in July Lexarfiled a shelf registration to sell up to 6 million shares, or $50 millionof stock.

Last year SanDisk claimed nearly five times Lexar's revenue. AndSanDisk has a market cap of nearly $1 billion to Lexar's $210 million."Lexar just doesn't have the same flexibility," says Patel.

Insiders Getting Out

"Our thesis is, it appears that there's a pretty large supply coming onin the flash memory area," he says. "And although revenues appear to begoing up at Lexar, if things are so great, why is there a gigantic rush outthe door?" A recent spate of insider sales doesn't include just management,but also venture capital investors, he says.

Indeed, even Coster and other analysts seem uneasy about the extent ofinsider selling. Insiders have sold 9.36 million shares in the past six months, according to Yahoo!. One board director has sold nearly 1 million shares since this summer, while two venture capital investors have shed 6 million and 1.7 million shares each.

Asked to address the sales, Perez says, "There are specific reasons foreach of the insiders that have sold. The venture capitalists on the boardare still board members; they still believe strongly in the company, butthey're also running venture capital firms, and each had requirements thatthey sell some shares. I'm sure they were going to use

the proceeds forsome other venture effort."