M-Systems Flash Disk Pioneers (Nasdaq: FLSH) CEO Dov Moran is an excellent entrepreneur, inventor and manager. After 13 years in charge of a public company, however, he still has trouble fathoming Wall Street’s unwritten rules. Not issuing guidance for the year at the end of January is like telling investors, “I have no idea what will happen tomorrow morning.” Believe me, he has got an idea, not only about this year, but also about quite a few years ahead. How do I know? For example, M-Systems hasn’t finished the second building on its site in Kfar Sava, and it’s already digging the foundations for a third building. That means that Moran knows what the company’s needs will be in 2008. At this rate, he could soon launch a real estate fund entitled M-Systems REIT.
What investors discovered last week about M-Systems, which deeply disappointed them, was that the company paid a heavy price for everything it sold in the fourth quarter of 2005 beyond its original sales guidance of $40 million. The reason is that M-Systems bought its chips, its raw materials, at high prices on the open market, because it reached the limit of its low-price supply contracts.
That’s the price that M-Systems is paying for two things. The first is not having its own fab, like SanDisk Corporation (Nasdaq: SNDK), for example. The second is the strategic decision it made not to repeat its mistakes of late 2003-early 2004, when it bought large stocks in advance at high prices, while the market chip shortage later turned into a surplus, and M-Systems eventually had to write off inventory. The ridiculous aspect is that investors prefer that M-Systems should not take the risk of owning a fab, and should not hold high stocks.
Personally, I don’t understand the great hysteria about M-Systems’ low gross profit margin, as long as its sales and profits are soaring, and as long as the company doesn't stop innovating. It’s true that I would prefer Check Point’s (Nasdaq: CHKP) gross profit margin. At the end of the day, however, M-Systems CFO Ronit Maor is going to the bank to deposit $0.50 per share in profit, more than double the preceding year. Even with his company’s astronomical profit margin, Check Point executive VP and CFO Eyal Desheh will deposit $0.35-0.37 per share in profit, compared with $0.31 in the preceding year profit growth of only 20% at most.
By the way, in the fourth quarter of 2005, M-Systems passed Check Point for the first time in both quarterly sales and profit per share, even though some say this is like comparing apples and oranges, because there is no connection between their respective sectors. In my opinion, this is an important milestone in the history of the flagships of Israeli technology.
In their rush to sell M-Systems’ shares last week (trading volume set a record of almost 10 million shares on Wednesday), investors apparently didn’t notice two important comments by Moran about 2006. The first was that he hopes growth will be at least as high as in 2005. In my opinion, on the basis of this declaration, and even though the company will issue guidance only in April, most analysts will now include an expected sales turnover this year of at least $750 million in their reviews.
Sales of $750 million means at least 38% growth this year, compared with 55% last year. If management’s guidance in April says this, and assuming that, as in all recent years, the company meets its guidance, then M-Systems’ current p/e ratio is absurd, not to mention its sales multiple. At a share price of $28.36, the p/e ratio has already plunged below 20, because it’s possible that these sales could easily turn into a profit of over $1.50 per share. M-Systems’ sales multiple has fallen to 1.7. After publishing its results, SanDisk will probably be traded at a p/e ratio of 30, and a sales multiple of 5.
Moran’s other important statement was that M-Systems would unveil “a significant technological breakthrough” this year, which would improve its cost structure, i.e. its low gross profit margin. Deutsche Bank analyst Dan Harverd hurried to raise his target price for the share to $41. He reminded us that Moran has used the expression “technological breakthrough” only three times previously: when he announced the DiskOnKey (DOK), the Mobile DiskOnChip (MDOC), and the U3. Each of these three growth engines is contributing, and will contribute, hundreds of millions of dollars a year in sales to M-Systems.
Published by Globes [online] - www.globes.co.il - on January 29, 2006