Samsung Buying Sandisk? (Update)

1. The royalty/licensing trap.

The portion of SanDisk revenue generated from royalty and licensing fees has been increasing steadily even as weak pricing conditions hurt product sales. While this is good news for the company, it hurts customers like Samsung Electronics, which see their payments helping to prop up a rival in a price-sensitive market. Eliminating the royalty payment or reducing it substantially is now a key goal for Samsung, which sees this as a key competitive advantage in several of its market segments.

2. Strike while the enemy is down.

SanDisk's stock price has fallen sharply over the last year, providing an opening for a customer already irritated over a protracted negotiation over licensing fees. Although Samsung's $26-per-share offer for SanDisk looks attractive—representing a hefty 73 percent premium to SanDisk's closing price the day prior to the offer—it is still less than half the stock's 52-week high of $55.98. In fact, Samsung had previously indicated it would be willing to pay a higher premium when the companies first began discussing the acquisition in May, according to SanDisk.

3. Overcapacity hurts everyone and someone will do something about it.

All the companies in the NAND flash memory business are hurting, badly. SanDisk just happens to be in a more difficult position than rivals Samsung and Toshiba Corp. because it is more dependent upon that market segment for a majority of its revenue. As a result of overcapacity, the flash memory market is swamped with excess products, turning the segment into a buyer's market for OEMs. This is hurting everyone, and since anti-competition rules make it illegal for the rivals to engage in price fixing, the best solution currently available to flash memory suppliers is to close down some plants. Buying SanDisk would give Samsung the opportunity to tamp down on supply by cutting off production.

4. Buy one, get something else free.

Samsung executives would never admit this, but buying SanDisk would give the Korean company a great opportunity to tweak another rival's nose. Samsung and Toshiba are locked in a fierce struggle for market share in several segments of the semiconductor market. So far, neither company has been able to upend the other. A successful takeover of SanDisk by Samsung would cause a great deal of consternation at Toshiba, which has two significant NAND flash wafer joint ventures with SanDisk and has contributed millions of dollars to fund the partnership.

5. Samsung is no longer the same.

Lee Yoon Woo, Samsung's new CEO, is making a statement with the SanDisk offer. He wants the market to know the company is adopting a different operational strategy compared with the more staid style of his predecessor. The old Samsung made few, if any, acquisitions and relied on internal R&D to fuel growth. The new Samsung is forcefully telling the market it wants to be a major player in any consolidation of the semiconductor market. No longer will Samsung hang back while others make acquisitions that could end up limiting its growth. The new Samsung wants to become a truly global player and name brand. Strategic acquisitions will give it that opportunity and there's no better starting point than with a customer it already knows inside out.

PHILADELPHIA — First things first: SanDisk Corp. will most likely be acquired by a rival. The only outstanding question is which of its NAND memory competitors or partners will buy the Milpitas, Calif., company.

Now that Samsung Electronics has let the acquisition genie out of the bottle, SanDisk's days as an independent entity are almost certainly over despite the poison-pill provision the board of directors has adopted to stave off any unwelcomed propositions.

That SanDisk would become a pawn in a high stakes game for dominance in the NAND flash market segment was almost inevitable. It's once rapid growth has stalled due to the deadly combination of slowing demand, overproduction and falling prices. Moreover, SanDisk's relatively strong position in several markets and rich royalty revenue base make it an inviting target for the likes of Samsung and Toshiba.

Additionally, Samsung and Toshiba are bitter rivals seeking leverage over each other in several markets. The addition of SanDisk would give the winner in the SanDisk sweepstakes a significant edge in the memory over the loser.

What does Samsung stand to gain by purchasing SanDisk? A successful takeover by the Korean giant would enable Samsung mop up some of the excess capacity in the NAND flash memory market, a move that should boost prices and help improve the company's operating position in that market segment.

SanDisk's licensing and royalty revenue is a major attraction for Samsung. The U.S.-based company generated almost 16 percent of its sales in the June quarter from intellectual property, a sharp increase from 13 percent of sales in the second quarter of 2007. Samsung reportedly pays a substantial amount to SanDisk each quarter for the right to use SanDisk technology.

Furthermore, Samsung has tremendous leverage over SanDisk. It is the company's biggest customer and contributes up to 14 percent of SanDisk's quarterly revenue through direct product purchases and royalty payments. No other customer represented more than 10 percent of SanDisk's revenue in the June quarter, according to the company.

Samsung is by far the leading global NAND flash memory supplier with a 42 percent market share, according to iSuppli Corp., which estimates the Korean company was the only "profitable NAND supplier during the second quarter due to its divese produce line." A successful acquisition of SanDisk would give Samsung an opening into the U.S. flash storage card market where SanDisk leads with a 36 percent market share, iSuppli said.

Why SanDisk?

SanDisk became a target because of events largely outside its control. The company's revenue exploded in recent years and more than doubled between 2005 and 2007, rising to $3.9 billion last year from $1.8 billion two years earlier.

The outlook for this year isn't that positive, however. Revenue for 2008 is expected to slow 14 percent to $3.36 billion, from $3.9 billion in 2007, as prices of memory chips continue to fall.

SanDisk's 2009 revenue will likley improve but not by much, according to analysts polled by Thomson Reuters. The analysts estimate SanDisk's 2009 annual revenue will only improve fractionally next year to $3,37 billion. Blame the revenue fall off on worsening price conditions in the NAND market, a result of the additional manufacturing capacity added in recent years. The increase in volume drove down prices sharply as vendors sought to retain market share. In 2007, for instance, the price of NAND memory ICs decreased 60 percent.

Prices have continued to decline this year, and remain a frustrating problem for NAND manufacturers, especially vendors forced to divert huge amounts of money into operational expenses at a time of spiraling plant expenses. With new fabs planned, and capacity utilization rates dropping, the industry sector is clearly overdue for consolidation.

Will Toshiba fight for SanDisk?

It's unlikely Toshiba will stand by idly while Samsung walks off with SanDisk, although the Japanese company may not be able to compete in a bidding war with its Korean rival.

Still, there's a great deal at stake for Toshiba, which could face serious hurdles in its NAND flash memory production operation if Samsung scuttles pre-existing agreements after gaining control of SanDisk.

Toshiba and SanDisk are partners in two joint ventures called Flash Partners and Flash Alliance. Both manufacture NAND flash memory on 300-millimeter wafers.

SanDisk has a 49.9 percent interest in each of the two JVs, a stake that means it must agree to use certain portions of their production, and also "fund direct and common research and development expenses" related to the operation of the units.

A third JV between Toshiba and SanDisk produced NAND flash memory on 200-millimeter wafers, but the partners have decided to close the business because it was "no longer cost effective relative to current and projected market prices for NAND flash memory," according to a SanDisk filing with the U.S. Securities and Exchange Commission.

Unwinding all these complex relationships may not be easy for Samsung if it succeeds in gaining control of SanDisk due to contractual obligations related to JV funding, along with iron-clad product purchase commitments.

"SanDisk's large cash commitments to capacity expansion at its manufacturing joint venture with Toshiba, as well as lease guarantees and wafer purchase obligations, could still complicate matters," said Daniel Berenbaum, an analyst at SG Cowens Securities Inc.

"There is also the possibility of onerous change of control provisions in the JV agreement," he added. "If Toshiba feels that its own prosperity is threatened it could attempt to scuttle a deal or, conversely, make a counter-offer of its own."

The more likely outcome is that Samsung increases its already high offer and extend a sweetener to Toshiba while allaying antitrust concerns with additional concessions.

Should all these scenarios fail, SanDisk's board of directors must pray for pricing sanity to return to the flash memory market. Otherwise, the company's market valuation will again slide, and it might have to accept an even lower offer from a different suitor.