Flash Free-for-All?

SanDisk's purchase of M-Systems augurs more consolidation among makers of flash memory for consumer electronics

There's a special kind of memory used to store digital data in a host of devices—from cameras to music players. It's known as NAND flash, and judging from the M&A market, it's suddenly one of the hottest areas in tech. SanDisk, a company that specializes in flash-memory products for the retail market, just spent $1.35 billion for Israeli firm M-Systems, which makes storage devices for computers. That was the second deal of its kind since March. And it's unlikely to be the last.

SanDisk (SNDK), which generated $2.3 billion in sales in fiscal 2005, has embarked on a quiet marketing campaign against Apple Computer's (AAPL) iPod family of digital music players (see BusinessWeek.com, 5/8/06, "Will SanDisk Sour Apple's Tune?"). Through the deal, it gains an ally in M-Systems (FLSH), the $614 million Israeli firm that was one of the first companies to market and sell what has come to be called a keychain, or thumb, drive—one of those little dongles that plug into the USB ports on computers and are used for handy storage.

The combination makes sense for both, and investors in M-Systems drove the stock up by more than $4, or 14%, on July 31. Analysts Sidney Ho and Joe Osha of Merrill Lynch say the deal will contribute slightly to SanDisk's earnings in 2007 and be neutral in 2006. "The accretion could increase if SanDisk is able to shift some of the M-Systems sourcing to captive supply," they wrote in a note.

SanDisk's chip manufacturing is done under a joint venture with Toshiba (TOSBF). The cost structure of that arrangement helps SanDisk eke out a high margin even on a relatively low volume. That gives the company a leg up in its rivalry with Apple and others like Creative (CREAF) in sales of MP3s. It also gives SanDisk fatter margin than M-Systems, note Osha and Ho. M-Systems gets the flash chips used to make its products from chip manufacturers including Toshiba, Japan's Renesas Semiconductor, South Korea's Hynix Semiconductor, and Spansion (SPSN), the former flash-chip division of Advanced Micro Devices (AMD). It has gross margins of about 25% compared with 42% for SanDisk.


  The SanDisk acquisition comes on the heels of the purchase of Lexar Media (LEXR) by Idaho-based Micron Technology (MU). One reason Micron wanted Lexar was to boost its own exposure to the red-hot flash-memory market as a hedge against Micron's traditional core business of DRAM memory chips, the main memory used in PCs and servers. The other motivation was Lexar's retail distribution network, which is similar to that of SanDisk.

Flash-memory cards—mostly aimed at digital camera users—are sold by retailers as varied as Best Buy (BBY) and Wal-Mart (WMT). SanDisk's advantage here, says iSuppli memory-chip analyst Nam Kim, is that it can supply itself with the most expensive component in these products—the flash chips—at cost, and then distribute them widely to retail stores. "The flash chip accounts for about 80% of the cost in these products," he says.

So where will the next deal happen? Look to South Korea, where chip giant Samsung is the biggest supplier of flash chips and has a healthy business selling Samsung-branded flash-card products through retailers in China and elsewhere in Asia. Samsung might want to take its brand to the U.S., possibly by buying a company with an established retail presence. Possible candidates include Imation (IMN), the Minnesota-based $1.2 billion data-storage concern that on July 31 announced a new flash-drive product aimed at students. Samsung's neighbor, Hynix Semiconductor, is also a major flash supplier that might try to make a play for retail business.


  Other companies with heavy exposure to the consumer flash-memory business include Japanese electronics giant Sony (SNE), which not only makes its own keychain drives, but manufactures its own proprietary flash-memory-card products under the Memory Stick brand.

Demand for those products isn't likely to slow anytime soon. ISuppli's Kim says the market for NAND flash chips will be $14.7 billion this year, compared with $10.7 billion in 2005. It's expected to grow to nearly $24 billion in 2009. At least one demand driver is the expected onset of personal computers that use a combination of traditional hard drives and flash-memory chips to store data. Microsoft (MSFT) has said its next version of Windows, known as Vista (expected in early 2007), will support these hybrid drives, and hard-drive manufacturer Seagate (STX) has already shown just such a drive.

Kim says he doesn't expect these hybrid drives to impact the supply for flash chips in the short term, as the technology will take some time to migrate into the mainstream PC market. But within three years, it could cause demand to surge considerably. Meantime, Apple is expected to revise its iPod nano line to include new models with higher storage capacities, which is sure to boost short-term demand. Notes Kim: "The market was oversupplied until Apple started selling the iPod nano."

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