Upon filing its fourth quarter statement,

M-Systems Flash Disk Pioneers

(Nasdaq:FLSH) warned that it would not meet expectations for the first quarter. Later the company warned that its results would be even worse than previously expected: its revenues would slide to $15 million for the first quarter and it would shift to a loss of 8 cents per share.

Yesterday Merrill Lynch belatedly updated its coverage of the company. The bank is not sanguine about M-Systems' short-term prospects, but still rates the company a Long-Term Buy.

Analyst Ilana Treston accepts the company's guidance for the first quarter. She also estimated its results for the year, which the company neglected to do.

For 2001, Treston predicts a loss of 27 cents per share, up from earlier estimated earnings of 31 cents per share. She is deeply pessimistic compared with Salomon Smith Barney, which is still banking on a profit of 18 cents per share for M-Systems in 2001.

The problem lies in the flash-memory market, which has been slumping together with the semiconductors market. Chip prices fell as inventories became bloated. M-Systems found its customers delaying orders or canceling them altogether.

Treston notes that the semiconductors business cycle swung down from 1996 to 1998. But the difference this time, she says, is that the entire technology industry is slowing.

Expensive alternatives are out

The most significant development for M-Systems is the slowdown in the market of chips for PCs. She sees slowing sales of its FastFlashDisk (FFD) memories for personal computers, which serve in the stead of hard disks. But they are expensive, and telcos are slicing their spending. Treston does not see salvation in the fact that

Nortel

(NYSE:NT) is using the FFD.

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FFD contributed 12% of M-Systems' total revenues in 2000. But their sales slowed by 40% in the first quarter.

Meanwhile, M-Systems' orders are dropping worldwide, making the future hard to predict. A few weeks ago SSB assessed that the company's visibility is limited to about four weeks ahead. But Merrill Lynch says it is higher, in certain areas. For instance, orders from China are progressing as planned, as are orders for DiskOnKey (DOK), which is being marketed by

IBM Corporation

(NYSE:IBM).

Waiting for orders

The key word at this time is waiting. M-Systems is waiting for orders by its telco customers, which are waiting for consumers to order goods. The rally is not likely to come any time soon. The signs of the slowdown are evident in sales of M-Systems' flagship product, the DiskOnChip DOC.

DOCs contributed 80% of M-Systems' sales in 2000. A 50% decline in DOC sales in the first quarter compared with the fourth quarter will clearly hurt the company.

Treston does not see DOC sales rallying before the fourth quarter of 2001. Moreover, even if M-Systems' customers are not yet pressing it to lower prices, they probably will. The company's profit margins are therefore likely to shrink and close to zero growth can be expected for the second and third quarters of 2001. But, Treston warns, the situation could be even worse.

M-Systems is tightening its belt, but continuing to invest in R&D. Among its investments is Fortress, a company developing security systems for M-Systems' flash products. The company is also promoting products still selling well, including its DOK. Merrill Lynch expects M-Systems to meet DOK target sales of $5 million in 2001.

Although M-Systems reported tentative contract wins, even when it gets the proceeds, they will only neutralize its increasing investment, say the analysts.

Yesterday M-Systems announced it will be incorporating the Nucleus Plus RTOS system made by Accelerated Technology in its DOCs. From the press release: Nucleus PLUS is a scalable and flexible real-time kernel. Nucleus PLUS provides a complete set of dynamic multitasking facilities including task communication, task synchronization, programmable timers and memory management.

M-Systems can take comfort in the fact that Merrill Lynch reiterated its Long Term Buy rating for the company. It also has $110 million in hand, a nice cushion for a company with a burn rate of $8 million per quarter.