Center for Quality Analytical Data

Memo
To: Frank DeGeorge, President & CEO - CQAD From: Robert Hammer, Equity Analyst - CQAD Date: 3/25/2010 Re: Final Report: Recommendation for SanDisk Corporations Equity

This memorandum has been prepared to conclude the analysis of SanDisk Corporation (SNDK or the Company). Analysis includes a look at SanDisks prospects for growth and major risk, industry analysis, major developments in the financing activities, capital structure, financial flexibility, operating capability, and liquidity of SNDK, and an in-depth look into SNDKs operating activities and profitability. Following is a detailed explanation of the appropriate financial information and a recommendation to buy, sell, or hold the Companys equity.
Stock Price History 3/25/2010 2009 2008 2007 2006 2005 2004

34.95

28.99

9.60

33.17

43.03

62.82

24.97

Summary and Conclusion SanDisk is an extremely profitable company with great growth potential, above average financial flexibility, operating capability, and liquidity. The Companys stock is currently trading at a price of $34.95 as of March 25, 2010. This is above the range of estimates for its stock price if we assume that the P/E ratio will gravitate towards the growth rate over the coming two years. However, I believe because of SNDKs tremendous growth potential it will continue to be priced by the market above its sustainable growth rate. Using a multiple of 22.82x my estimate for 2010 EPS gives me a fair value of $35.38 a share. I believe the market price to be currently fair valued by the market and recommend a HOLD on the stock. Industry Analysis SanDisk Corporation is the largest supplier of flash storage card products based on NAND technology. NAND is used in digital cameras, multimedia cellular phones, USB flash drives, gaming devices, laptop computers, personal computers, audio players, and video players. The company derives its revenue from two segments, the products segment (88.4% of 2009 revenue) and the license & royalty segment (11.6% of 2009 revenue). As the largest maker of flash memory products SanDisk stands to benefit greatly from the rising demand of smart phones, MP3 players, tablet PCs, and other devices that use such memory. Growth opportunities appear numerous with the rising demand for eReaders (Kindle), tablet PCs (iPad), and SSDs (solid state hard drives). I believe the growth prospects far outweigh the risk factors in the years ahead.

Financial Position SanDisk Corporation displays promising financial flexibility and operating capability, as well as an appropriate level of financial leverage and a strong capital structure. The Company has leveraged up since 2006 with the issuance of debt to finance acquisitions and joint ventures. At the same time it has maintained its average level of financial flexibility. This combination has increased the overall financial position of SanDisk over the previous six years. Liquidity is not of any concern as SNDK can easily cover all of its short-term obligations. The Company appears to be investing in the future through acquisitions and joint ventures and seems to be perfectly capable of remaining a going concern. Management is financially knowledgeable and reinforces SNDKs flexibility to respond to unforeseen challenges and opportunities. Capital Structure The tables below identifies the components of the Companys capital structure and the percentage of total assets that each of the components represents for. All dollar amounts are in thousands.

SanDisk Corporation Capital Structure Operating Liabilities Financing Liabilities Equity Total Assets Percent of Total Assets Operating Liabilities Financing Liabilities Equity Total Assets
WDC 2009 2009 2008 2007 2006 2005 2004

$ 2,219,000 400,000 4,709,000 $ 7,328,000

$ 1,081,699 $ 1,537,476 $ 1,050,202 $ 974,649 $ 588,921 $ 374,494 1,009,722 954,094 1,225,000 1,225,000 3,910,298 3,440,570 4,959,617 4,768,134 2,531,266 1,945,686 $ 6,001,719 $ 5,932,140 $ 7,234,819 $ 6,967,783 $ 3,120,187 $ 2,320,180 2004 to 2009 2% 17% -19% 0%

30% 5% 64% 100%

18% 17% 65% 100%

26% 16% 58% 100%

15% 17% 69% 100%

14% 18% 68% 100%

19% 0% 81% 100%

16% 0% 84% 100%

Of some concern may be SNDKs ability to meet its short-term obligations because of its growing use of debt financing. As stated above, SNDK is more than ready to meet any and all short-term obligations arising in the near future. Its main competitor, Western Digital, is better able to meet interest payments, but SNDKs Interest/Operating Cash Flows is only 2.66% and this represents a rather large margin of safety. SNDK does not pay dividends.
WDC 2009 SNDK 2009

Interest Paid Interest/Op. CF

8,000 0.41%

13,001 2.66%

Also, SanDisk Corporations liquidity ratios suggest a greater ability to meet short-term obligations than Western Digital. WDC 2009 SNDK 2009

Working Capital Current Ratio Quick Ratio Cash Ratio

$ 2,697,000 2.3 2.0 1.4

$ 2,043,664 3.3 2.5 2.2

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Operations and Profitability SanDisk Corporation is an extremely profitable company, earning nearly $320 million dollars for fiscal year 2009. However, the companys diluted EPS per share is actually down 1% over the last six years. This drop seems due to a loss of operating efficiency between years 2005-2007 that resulted in major restructuring efforts to bring operational expenses to appropriate levels relative to net revenues. This was done by implementing a companywide expense control program as part of the restructuring. Recurring EPS rebounded from $(2.46) in 2008 to $1.37 in 2009 reflecting a recovering global economy and cost savings from restructuring. These programs seem to be having a beneficial effect on the firms efficiency and profitability. A continuation of the trend into 2010 will be proof of SanDisk revitalized operations. SNDKs results from operations can be seen in the chart below.

Western Digital YE 7/2 2010 2009 2008

SanDisk Corporation 2007 2006 2005 2004

Revenues Product revenue License and royalty revenue Total Revenues Total cost of product revenues Gross profit (Value Added) Net income (loss) to common shareholders Diluted EPS per share (as reported) Diluted EPS per share (recurring)

9,850,000 9,850,000 7,449,000 2,401,000

$ 3,154,314 $ 2,843,243 $ 3,446,125 412,492 508,109 450,241 3,566,806 3,351,352 3,896,366 2,282,180 1,284,626 3,288,265 63,087 2,693,647 1,202,719

2,926,472 331,053 3,257,525 2,018,052 1,239,473

2,066,607 239,462 2,306,069 1,333,335 972,734

1,602,836 174,219 1,777,055 1,091,350 685,705

$ $ $

1,382,000 5.93 5.93

$ 318,314 $ (553,797) $ 237,268 $ 423,051 $ 386,578 $ 266,750 $ $ 1.79 $ 1.37 $ (8.82) $ (2.46) $ 0.81 $ 1.01 $ 0.96 $ 2.04 $ 2.00 $ 2.00 $ 1.41 1.41

Historically, between years 2004-2006, SanDisk ROE averaged 14.2% and EPS growth averaged 27%. Since then ROE fell to a low of -13.2% in 2008 and EPS growth went negative between the years 2006-2008. ROE has now recovered to 8.7% for fiscal year 2009 and EPS growth is now positive. The restructuring efforts have, in my opinion, been effective and as a result of these efforts, combined with SanDisk strong capital structure and financial flexibility, future growth prospects appear bright. The operating results from 2010 will allow us to further determine if the company is bound for a turnaround. SNDKs complete disaggregation is displayed below.
Western Digital YE 7/2 DeGeorge ROE Disaggregation 2010 2009 2008 SanDisk Corporation 2007 2006 2005 2004

Gross Profit Margin X Operating Retention = Operating Margin X Non-Operating Retention = Profit Margin X Asset Turnover = Return on Assets X Financial Leverage = ROE

24.4% 63.5% 15.5% 90.6% 14.0% 1.56 21.9% 1.60 35.0%

36.0% 40.5% 14.6% 61.1% 8.9% 0.60 5.3% 1.62 8.7%

1.9% -1426.1% -26.8% 61.6% -16.5% 0.51 -8.4% 1.57 -13.2%

30.9% 25.7% 7.9% 76.9% 6.1% 0.55 3.3% 1.46 4.9%

38.0% 45.9% 17.5% 74.3% 13.0% 0.65 8.4% 1.38 11.6%

42.2% 59.3% 25.0% 67.0% 16.8% 0.85 14.2% 1.22 17.3%

38.6% 61.0% 23.6% 63.7% 15.0% 0.77 11.5% 1.19 13.7%

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Business and Investment Risk NAND memory is essentially a commodity market; therefore, product differentiation is difficult. An oversupply could destroy the markets pricing power, like it did in 2008. However, there should be shortages continuing into late-2011. If prices start dropping again SanDisk must be able to cut cost as fast as prices. They were unable to do this in 2008. The global financial crisis also slowed demand for electronic gadgets. If the economy faces a double-dip scenario it will substantially impact the demand for SanDisk Corporations products. SanDisk receives 44% of its revenues from its top 10 customers and licensees. Losing any of these important customers could result in a large drop in orders, reducing revenues, and hurting their bottom line. Growth Potential and Recommendation SanDisk Corporation has tremendous growth potential. Memory demand of all types is booming. SanDisk is positioned to supply the soaring market for mobile device memory. Mobile sales have exploded from 25% of SanDisk sales in 2005 to 49% in 2009. Also, the Company is not heavily exposed to a faltering U.S. consumer, with only 29% of 2009 revenue coming from the United States. SanDisk also has at least three to five quarters advantage over its competitors with its X3 memory technology. This gives them and their partner Toshiba a 10-20% cost advantage. In addition, cost of goods sold continues to fall as management is now heavily focusing on improving the utilization rate. SanDisk is also making another strategic change to its NAND memory supply. Currently, the company produces all the NAND it needs internally (known as captive supply). Management has now decided to rely more on external sources (known as non-captive). The advantage of relying on non-captive supply is particularly pronounced during industry downturns. In such conditions, SanDisk would be able to use the flexible model to its advantage, as it would not be required to make compulsory purchases that are necessary under the captive model. This will ultimately save production costs. With higher profits for shareholders on the horizon due to restructuring efforts and the large growth of the memory market, SanDisk will be more than able to invest for growth. The Company does not pay a dividend; therefore all of their recurring net income from continuing operations is available for investment in future growth. This means that SanDisk should command a higher rate of growth than the average dividend paying company.

Western Digital YE 7/2 2010 2009 2008

SanDisk Corporation 2007 2006 2005 2004

12/31 Closing Price Return on Equity Dividend yield Dividend Payout ratio Retention Rate Sustainable growth rate

30.20 35.0% N/A 0% 100% 35%

28.99 $ 8.7% N/A 0% 100% 9%

9.60 $ -13.2% N/A 0% 100% -13%

33.17 $ 4.9% N/A 0% 100% 5%

43.03 $ 11.6% N/A 0% 100% 12%

62.82 $ 17.3% N/A 0% 100% 17%

24.97 13.7% N/A 0% 100% 14%

In calculating a growth rate to use in valuation I believe the sustainable growth rate is best. This is essentially using Return on Equity (ROE) as a growth rate since the Company does not pay a dividend and does not plan to do so in the future. Also, the growth rates in diluted EPS per share are too sporadic to have any predictive ability.

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I decided to use an average of what I call the normal years between 2004-2006 and 2009 to represent my sustainable growth rate. This leaves out the years of 2007-2008 where SNDK went through major restructuring and the global financial crisis occurred. These years are not representative of SanDisk growth potential and are non-recurring. Therefore, they should not be used in forming a growth forecast of SanDisk future cash flows. I have also used an average of the normal years to find the correct P/E multiple to formulate an equity price target. After calculating a sustainable growth rate of 13% I expanded the range to include a low of 9% and a high of 17%. Over a long period of time the P/E ratio will gravitate towards the sustainable growth rate. However, because of the abnormal amount of growth potential that SanDisk has I believe the market will continue pricing SanDisk at a P/E multiple above its sustainable growth rate in the near future. As a result, I believe it will take more than two years for SanDisk P/E multiple to gravitate towards its sustainable growth rate. The average P/E of SanDisk stock over the normal years is 22.82 and in normal times, which I expect to occur if the U.S. economy avoids a double dip scenario, SanDisk stock will trade around a 22.82x multiple.
Possible Range of Growth Rates
Growth Rate 9% 13% 17% 2010 EPS 1.50 1.55 1.61 2011 EPS 1.63 1.75 1.88

If P/E gravitates towards the growth rate

P/E = Growth Rate Growth Rate 9% 13% 17% Est. 2010 13.46 20.16 27.29 Stock Price Est. 2011 14.67 22.78 31.93

If continued to be priced as it has in the past

P/E = 22.82 Growth Rate 9% 13% 17% Est. 2010 34.13 35.38 36.63 Stock Price Est. 2011 37.20 39.98 42.86

SanDisk is currently trading at a price of $34.95 as of March 25, 2010. This is above the range of estimates for its stock price if we assume that the P/E ratio will gravitate towards the growth rate over the coming two years. However, I believe because of SNDKs tremendous growth potential that SNDK will continue to be priced by the market above its sustainable growth rate. Using a multiple of 22.82x my estimate for 2010 EPS gives me a fair value of $35.38 a share. Changing my estimate of EPS for negative and positive scenarios gives a target range of between $34.13 and $36.63 a share for 2010. SNDKs current price of $34.95 is within my range and I recommend a HOLD for SanDisk Corporations stock. At this price, even though SanDisk is a great company, if the P/E gravitates towards the growth rate in the coming years there is only downside potential for SNDKs stock. Final recommendation = HOLD.

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Appendix A Reconciliation of Recurring NICO and Calculation of Normalized Tax Rate

Western Digital YE 7/2 Reconciliation to Reported 2010 2009 2008 SanDisk Corporation 2007 2006 2005 2004

Impairment of goodwill Impairment of acquisition - related intangible assets Amortization of acquisition - related intangible assets Restructuring and other Taxes at normalized rate After tax impact Unusual taxes Net change in NICO NICO as reported Recurring NICO NICO (loss) to common shareholders per share $

5.93 $ -

1,167 38 (445) 760 (97,755) (96,996) 415,310 318,314

$ 845,453 $ $ $ $ 175,785 225,600 17,069 25,308 17,432 35,467 6,728 (396,956) (11,843) (89,845) 676,818 20,193 153,187 756,009 26,459 70,968 194 134 1,432,827 46,652 224,155 194 134 (1,986,624) 190,616 198,896 386,384 266,616 (553,797) 237,268 423,051 386,578 266,750 (2.46) $ 1.01 $ 2.04 $ 2.00 $ 1.41

1.37 $

SanDisk Corporation 2009 2008 2007 2006 2005 2004

Income (loss) before provision for income taxes Provision for income taxes

503,801 (1,952,374) 88,491 34,250

352,658 156,831

430,708 230,193

613,307 226,923

423,200 2,323,674 156,584 859,022 37.0%

Normalized Tax Rate - Excluding 2008 Tax Year =

Appendix B Financial Analysis Spreadsheet See attached excel spreadsheet in e-mail

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