Why SanDisk should hold out

SanDisk founder and CEO Eli Harari rebuffed Samsung’s buyout offer, saying it undervalued the company. Photo: SanDisk

Politics, as humorist FP Dunne famously put it, ain’t beanbag. If Dunne had spent his days observing Silicon Valley innovators instead of Chicago machine pols, he might have said the same about the flash memory business.

It’s cutthroat stuff. Just look at the standoff between ailing flash innovator SanDisk (SNDK) and South Korean powerhouse Samsung.

On the surface, this seems like a straightforward buyout attempt: Samsung is the world’s largest supplier of the chips that provide storage for gadgets like iPods, iPhones and digital cameras; SanDisk has a bucketload of flash patents worth a half billion dollars a year in licensing fees. SanDisk stock has taken a beating lately, so it makes sense that Samsung would try to buy the company out; it publicly offered $5.85 billion in cash for the company this week, or $26 per share.

Samsung, meanwhile, is doing fine. Though its stock is trading near 52-week lows on the Korea Stock Exchange, it has access to cheap financing through the South Korean government, and its broad portfolio of businesses selling cell phones, TVs, appliances and other electronics help to even things out. In its most recent quarter, it reported revenues up 24 percent from a year earlier, and profits that nearly doubled.

SanDisk didn’t appreciate Samsung’s buyout overture. Instead, it accused the company of trying to snatch its stock out of the bargain bin, an especially low blow at a time when the two are locked in patent negotiations. SanDisk founder and CEO Eli Harari issued a statement saying Samsung’s offer is “opportunistically timed at the trough of an industry-wide downturn,” and calling it a bum steer for his shareholders.

And he’s right. Flash memory experts knows that the business moves in boom-bust cycles – that’s why SanDisk’s five-year stock chart looks like a hamster’s EKG. (Flash prices typically rise at the end of the year, when gadget demand is high, then dip.) SanDisk has been in rough shape, but analysts I talked to expect the stock to come back.

Lately the flash industry has been in a deeper-than-usual bust, in part because of oversupply. Flash makers led by Samsung and Toshiba have poured billions of dollars into factories in a race to build the next generation of flash chips – chips good enough to pack the storage capacity of a PC into a gadget the size of a cell phone, or cheap enough to replace the hard drive in a mini-laptop. Meanwhile, the laws of supply and demand have gone to work. As Samsung, Toshiba and others have pumped more supply into the flash market, prices have fallen, profits have evaporated and SanDisk’s stock has lost more than $6 billion in value. (SanDisk has traded as low as $13 lately, down from $55 last October.)

All of which provides an opening for Samsung to take a shot at SanDisk. With its unsolicited bid, it potentially accomplishes a number of strategic goals:

• Savings. Samsung pays SanDisk hundreds of millions of dollars a year in licensing revenues, because SanDisk invented many of the key technologies behind flash By acquiring SanDisk out, it could eliminate those payments.

• Dominance. Japan-based Toshiba is Samsung’s biggest rival in the flash game, and for years SanDisk and Toshiba have worked together to build flash factories. (This must annoy Samsung to no end, since its licensing revenues are helping to feed a competitor’s arsenal.) If Samsung can take SanDisk out of the picture, it will change the economics of flash, potentially making it impossible for Toshiba to compete.

• Leverage. As Harari noted, the two companies are negotiating over license terms. If Samsung’s pressure tactics result in a better deal, it potentially means more money going into its own coffers, and less into SanDisk’s joint venture with Toshiba. “Samsung wants to bolster itself up against Toshiba,” says Tim Bajarin, who heads the Creative Strategies consulting firm. He doesn’t think Harari and the SanDisk board are likely to accept a Samsung offer. “Eli is very proud of what he built there. I think they’ll stand firm.”

But really, SanDisk would be foolish to sell out – it’s likely that regulators would reject a deal because of the power it would give Samsung. But more fundamentally, the flash industry is likely to head into another boom cycle in 2009, which could boost SanDisk’s stock and get the target off its back. Samsung knows this, too – earlier this year, Samsung executives told reporters that they expect the flash market’s volatility will get smoothed out as new PCs using flash storage enter the market and boost year-round demand.

If that pans out, companies like SanDisk can expect to see flash prices rise as thinner, lighter PCs ditch hard drives for flash – something that’s already happening with machines like the Asus eePC, the Dell (DELL) Inspiron mini 9, the HP (HPQ) mini, and Apple’s (AAPL) MacBook Air. That is, if SanDisk can convince its shareholders to hold out and ignore Samsung’s overtures.

So far, SanDisk investors don’t seem to be panicking. Its shares have risen to almost $21, still well shy of Samsung’s bid – suggesting that many investors don’t expect a deal to happen. That means for now, SanDisk probably has some time to play some survival politics, and save its skin.

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