No one in the capital market has any doubts about the phenomenal growth rates posted by M-Systems Flash Disk Pioneers (Nasdaq:FLSH). The company's revenue is growing steadily, and it is considered a market leader in its field. But the complaints investors and analysts direct to the company's offices in Kfar Saba are mainly about two things: M-Systems' gross profit margins, sometimes called its "soft underbelly"; and its net profit, which is not large as a proportion of sales. M-Systems too understands that growth alone is not enough, and the uncertainty over its gross profit, which can rise in one quarter and fall in the next, spoils its attractiveness.
On fact holds true: If M-Systems meets its target of $325 million in sales for 2004, that means 150% growth. If one adds the company's 101% growth in 2003, a rosy picture emerges.
M-Systems president and CEO Dov Moran says, "In the market fervor to check whether we've met quarterly forecasts or not, we feel that people are forgetting these growth rates. We've examined all the leading Israeli companies, and found that we were the only one to surpass the $100 million sales threshold and still double our sales the following year, solely from organic growth."
Still scarred from an acquisition
M-Systems designs and develops flash-memory storage solutions. The company targets two markets. Its DiskOnKey (DOK), a pen-shaped memory product that had $51 million in sales in the third quarter, is designed for the USB storage market. Its Mobile DiskOnChip (MDOC), which had $20 million in sales in the third quarter, is a storage solution for the wireless telephone market. MDOC is derived from the company's veteran DiskOnChip (DOC), which had $17 million in sales in the third quarter.
M-Systems hopes that, in 2004, revenue of $325 million will be accompanied by earnings per share of $0.57, or $17.2 million in total, all of which will come from organic growth. Over the years, M-Systems has acquired two small start-ups, and neither had sales at the time it was bought. "These were what I call 'expense companies', but we got good people from the acquisitions," says Moran.
"Globes": Why don’t you make acquisitions? You have $180.8 million in cash. It seems like the right thing to do.
Moran: "The truth is that achieving our growth rates is hard, and requires managerial focus. It's not easy. Acquisitions are not a wonder drug, and we were burned by an acquisition of a Taiwanese company seven years ago, which I would say left a deep scar.
"We certainly examine opportunities, and invest in effort in that, and we have even carried out due diligence on a few companies in recent years, but there's nothing on the agenda at this time. You know what, I hope that companies hear what I'm saying, and tell themselves, 'Let's go to M-Systems, maybe it will buy us.' If there's something good on the marketing or technological side, we're open to it. You can consider this an invitation for proposals."
What will happen to your gross profit margin in the fourth quarter and 2005? It isn’t that high.
"Not high? Maybe so, but our gross profit margin of 23.9% on sales for the third quarter isn’t that low, either. Do you know what Dell Computers' (Nasdaq:DELL) gross profit margin was? Only 18.5% of revenue. In any case, we intend to do better.
"There were a number of factors affecting this item during the quarter, some of which offset each other. First, we got stuck with a lot of inventory. We reassessed and cut it. On this point, I can reiterate something I've said before, and stand behind now, too: inventory in the fourth quarter will be a lot smaller, because we'll sell from it, and inventory won't be a factor in the beginning of next year. On the other hand, our products mix was a positive factor. We improved our profit margin because we had smaller DiskOnKey sales."
You have two agreements for the supply of NAND flash memory chips from two major companies: Samsung and Toshiba. Will you renegotiate these agreements in 2005 to get better terms?
"I don’t want to mention names, but I can say that I'd like to order greater quantities from the larger supplier, but there's a limitation. The agreement with the second manufacturer was signed in late 2003, when we had to ensure flash memory deliveries, and we didn’t sign an optimal contract. Why isn’t it optimal? Because we had to place orders three months in advance. For instance, I placed an order in April for July, and I wasn’t smart enough at the time to know that I'd need smaller quantities. That's one reason why we're stuck with inventory.
"So yes, we hope to revise the two agreements in 2005. With the large company, we'll raise the volume we can buy from it, while we're also in the midst of negotiations with the other. In addition, we hope to sign a delivery contract with another company in 2005."
On the basis of prior M-Systems' press releases, the large company Moran is referring to is Toshiba (TSE:6502; LSE:TOS; XETRA; AEX; Paris:TSBA), and the small one is Samsung (KSE: 830).
Why the CEO is frustrated
M-Systems' market is cyclical. We've talked about an inventory surplus in the third quarter. What do you see for the future?
"I'd say that we're seeing a shortage of flash memory components on the horizon. I can't foresee a specific time frame, but the switch from one cycle to another will be faster than people think."
Moran declines to say whether this will be the dominant market trend in the fourth quarter, but says it will happen soon.
Although it is growing, M-Systems' revenue line in not without problems, the biggest of which is falling DOK sales. "We've went through a serious period with DiskOnKey," says Moran. "We saw fantastic growth in the fourth quarter of 2003 and the first quarter of 2004, and we were pressed to make deliveries. The surge in demand caused us to order large quantities of components. The market ordered our products in large quantities, and became saturated. This wasn’t felt in the second quarter, but it was most certainly felt in the third.
"At the same time, prices started to fall drastically, and every customer with full inventories want to get rid of them fast. I'd say that our Japanese customers had made the largest orders and were stuck with the largest surpluses. Another factor that worked against us was a delay in orders for Christmas, which usually come in September, but failed to arrive this year."
While M-Systems kept its head above water, two other companies, normally considered competitors or at least comparable, were hit hard: SanDisk Corp. (Nasdaq:SNDK) and Lexar Media (Nasdaq:LEXR).
"The drop in DiskOnKey sales is temporary, and doesn’t characterize the market as a whole, which is growing. Our positioning for 2005 is excellent," says Moran. M-Systems has given up on a few customers that are in financial difficulties, or which M-Systems believes will soon become so.
M-Systems currently has 500 employees worldwide, of whom 400 are in Israel. Its operating expenses are expected to rise in 2005, partly due to hiring plans. The company hopes that new projects will also boost revenue. Moran, a development man at heart, is rather frustrated on this point. M-Systems has at least 15 large projects in the pipeline; technological developments that will make a quick return on investment. "Many of these are completely new ideas, while others are derived from our existing technology. The common denominator is that they need millions of dollars in investment. Regrettably, we're now working on the 2005 budget, and realize that we can't carry out all the projects. Some will undoubtedly die, while others will be integrated into our current product lines."
In addition to its existing products - DOK, DOC, and MDOC - M-Systems recently unveiled development of "MegaSim", a SIM card incorporating a flash memory chip for wireless devices. 30 employees are working on it. "We'll have MegaSim sales in the second half of 2005," says Moran cautiously. "We'll present our first models in early 2005, and our initial sales will presumably be at a loss. We began development over a year ago, and we've already invested over $10 million in it."
Will MegaSim become M-Systems' fourth leg?
"Calling it a 'leg' doesn’t sound good. I'd prefer to call it the 'fourth wheel of a car'. We plan to make M-Systems into a locomotive with a lot of carriages."
In the past, you have given indications that you would enter the blade server field, and it's known that you're cooperating with IBM (NYSE:IBM) on this. What's this all about?
"Any server is basically a box with a hard disk inside. For example, we have 40 servers at the company, and each hard disk requires some power, and can also break down. M-Systems has developed a flash memory solution that replaces the hard drive. We did in fact reach an agreement with IBM on this matter recently. The product is considered part of our embedded line. We therefore won't provide separate details about sales, even in the future, but they will soon amount to a few million dollars."
Published by Globes [online] - www.globes.co.il - on December 1, 2004