Pricing Problem Swats SanDisk

The shares slump nearly 17% in early trading.
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Updated from 8:52 a.m. EDT

Plummeting flash-memory prices and higher costs pinched

SanDisk's

(SNDK)

third-quarter profit, sending its shares tumbling early Friday.

While SanDisk delivered financial results that surpassed Wall Street expectations, investors were more focused on the 60% drop in average selling price per megabyte, a rate of decline that CEO Eli Harari said was faster than anybody expected.

The Milpitas, Calif., company said Thursday afternoon that sales for the three months ended Oct. 1 surged 27% to $751 million. Analysts polled by Thomson First Call were looking for $737 million.

A day after the report, both Citigroup and Oppenheimer cut their ratings on SanDisk's stock, and the shares were recently slumping nearly 17% to $51.41.

SanDisk pointed to robust demand for its cell-phone flash chips, as well as USB flash drives and MP3 players as big sources of growth during the quarter.

Net income fell to $103.2 million or 51 cents a share, from $107.4 million or 55 cents a share a year earlier. Excluding stock-compensation expense and the amortization of certain acquisition-related assets, SanDisk earned 61 cents a share, surpassing Wall Street estimates of 57 cents a share a year earlier.

Operating expenses such as research and development, as well as sales and marketing, were up sharply year over year. SanDisk said it decided to ratchet up its retail-product promotions during the third quarter as it saw its competitors lower prices.

Harari said in a news release Thursday that the company weathered the brutal pricing environment thanks to its "highly competitive cost structure" from the company's manufacturing joint venture in Japan.

Still, the company's product gross margin fell to 32% from 37% a year earlier.

The expectation was for margins to improve in the third quarter, says Pacific Growth Equities analyst Satya Chillara, whose firm makes a market in SanDisk shares.

"That didn't happen, so that's probably why the stock is getting hammered," said Chillara. "It tells you pricing is still brutal."

Flash-memory chips, which retain data even when an electronic device has its power switched off, are becoming increasingly popular in digital cameras, cell phones and other gadgets. But some analysts have raised concerns that the flash-memory market could be at risk of an inventory glut as the various chipmakers aggressively boost manufacturing capacity in the face of uncertain demand.

Harari said he believed supply and demand are in "reasonably good balance," with the upcoming holiday sales season expected to absorb the existing supply of flash chips along with the new supply coming to market.

The company did not provide specific revenue guidance for the fourth quarter but said that it expects total megabytes sold to increase by 50% to 60% sequentially. This would increase the total megabytes sold in 2006 by 200%, which is higher than SanDisk's original expectations for the year due to the strength of its mobile-phone chips and the increasing demand spurred by lower prices.

SanDisk said its product gross margin in the fourth quarter will range between 33% and 35% as average selling prices decline sequentially an additional 15% to 20%.

Analysts expect SanDisk to earn 79 cents a share on revenue of $954.9 million during the fourth quarter.

Harari reiterated his view that annual price declines between 40% and 50% are healthy for the flash market, as they allow flash-memory chips to become an affordable component in new types of electronics products. Ideally, SanDisk's manufacturing strategy enables the company to scale its costs down in line with the price reductions.

Harari said that with prices dropping 60%, some of SanDisk's competitors will find it more profitable to convert their production to DRAM memory instead of NAND flash.

"Sixty percent is not sustainable long term," said Harari.