Volatile Flash Memory Market Keeps Component Firm On Its Toes

Fears of a shortage of the key memory technology drove up prices this summer. This led some of the leading flash memory card makers to hoard Nand parts, said analyst Betsy Van Hees of Cowen & Co.

In August, prices reached $9.50 per eight gigabytes of Nand flash, affecting those who buy flash on the spot market. Some of these consumers make photo-storage cards for digital cameras.

About 30% of Silicon Motion Technology's (NasdaqGS: - ) sales come from that marketplace, said analyst David Duley of Merriman Curhan.

Silicon Motion designs and engineers controllers for flash memory cards and USB flash drives. The cards go into consumer electronic devices such as cell phones, cameras and MP3 players.

"When flash pricing is very high that typically means it's difficult to get flash," Duley said. "Customers of Silicon Motion had to wait until flash pricing was more moderate."

As Nand-flash prices wobbled between $8 and $9.50 in July and August, Silicon Motion's stock tumbled 43% to 16.60.

The Taiwanese firm's stock has since rebounded. But Chief Executive Wallace Kou still expects third-quarter sales not to budge from the previous quarter.

"Although the third quarter has typically been a strong period for us, we believe revenue will remain flat due to continued tight Nand-flash supply conditions," said Kou in a press release after second-quarter results in July.

"We view the current industry situation as short term in nature and are optimistic about the outlook of our business beyond the near term," Kou added.

Management expects sales to reach $43 million to $45 million in the third quarter. That is a 36% to 42% year-over-year increase, but largely flat on a sequential basis. The firm plans to report the results later this month.

Nand-flash prices have fallen 31% to about $7.25 since the peak, according to Cowen & Co. reports.

"While the near-term outlook is bearish, the market should begin to rebound by the fourth quarter," Van Hees said. "We believe the fear of a Nand-flash product shortage has generally subsided."

This bodes well for Silicon Motion. Despite the dim views for the third quarter, the firm was still able to report a strong second quarter.

Sales more than doubled to $44.1 million in the quarter, driven by growth in mobile storage devices. That category, which includes controllers for both flash memory cards and USB flash drives, gained 94% to $34.6 million.

Unit shipments of mobile storage products rose 152% to 73.1 million units. Overall, Silicon Motion shipped a record 78.5 million units, up 168% from last year.

Earnings rose 89% to 36 cents a share. Analysts polled by Thomson Financial expected 32 cents.

The firm's controllers perform a critical function in flash memory cards, directing the flow of data in the host device.

This means the company's controllers are used in nearly every Nand-flash application, Van Hees said.

"The company is a derivative play to unit growth in the Nand market," Van Hees said. "And we expect substantial Nand unit growth in 2008 and beyond."

According to Cowen & Co. reports, Nand-flash demand should grow 54% to 2.8 billion units shipped this year. That's expected to hit 5.8 billion by 2010.

Van Hees said supply will likely outpace demand for Nand-flash suppliers, squeezing margins.

But low prices make room for emerging products, she said. And anything that requires Nand-flash memory needs a controller.

Silicon Motion's first quarter is typically the slowest. But its recent $90 million buyout of Future Communications, or FCI, should help offset the cyclical downturn.

FCI is a designer of radio frequency integrated circuits for mobile TV and wireless communications.

It's already profitable and should help Silicon Motion move into mobile devices with video display, such as Apple's (NasdaqGS: - ) iPhones.

Silicon Motion's fabless model will also help during the seasonally slow time, Duley said. The firm outsources its manufacturing to cut costs that drag on profits.

"The first quarter is when fabless is good," he said. "When business is soft, you don't have all the overhead dragging you down. This business model also keeps margins high."

Margins in the second quarter led the field at 53%.

The firm has captured roughly 25% market share due to the fabless model as well as its close relationship with the suppliers of flash.

The company's team of engineers works hand in hand with suppliers developing new products. By the time production starts up, Silicon Motion's controllers are perfectly aligned to work with the Nand chip.

"Silicon Motion's competitors cannot keep up with that," Van Hees said. "They just don't have the technology or the engineering capacity that is required."

Solid state storage drives will be the next big target for the controller market, Van Hees said.

Solid state drives aim to replace hard disk drives. Roughly 300,000 SSDs were shipped last year. Van Hees expects shipments to grow to just over a million units in 2007 to reach 6.5 million units next year.

"The adoption of SSDs is likely to begin when pricing for SSDs reaches about $3 per gigabyte, which could occur as early as the second half of next year," she said.

"We expect solid state to be the next killer application for Nand flash and Silicon's controllers."