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Two Wide-Moat Ways to Play a Coming Memory Shortage

Pat Dorsey, CFA

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. Generally speaking, I am not a big fan of trying to make money on consumer trades. Consumer electronics, a certain gadget becomes popular, people become excited about it, want to buy the stock. Eh...Typically it's a tough way to make money, because product cycles are pretty short, margins are pretty thin.

However, there's an interesting trend that's been happening recently regarding some of the consumer electronics, like smart phones, that you all know and love, that may offer a pretty interesting opportunity to make some money in some pretty attractively positioned wide moat firms. With me is our senior analyst Andy Ng, who covers the chip space for us, to talk about this trend. Thanks for joining me, Andy.

Andy Ng: Hi.

Dorsey: So, big picture, flash memory, which is the kind of stuff you have in those little USB things you stick in your computer, has really been increasing in terms of demand lately. Why is that?

Ng: Flash memory isn't just in the USBs. You can also find them in your smart phones, even some netbooks, and your MP3 players, and so on. And, on the demand side, the growth in smart phones, the proliferation of smart phones, has really driven demand for flash memory in the last year.

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Dorsey: Solid state drives, too. These are these sort of new drives that you're seeing in laptops, and externally, that have no moving parts. It's all just this big hunk of flash memory, right?

Ng: Right, yes. Solid state drives also use flash memory. People think that... Well, they will ultimately replace some hard drives that are out there. And we think that, by the end of this year, when producers get the cost to about $1 per gigabyte, proliferation of solid state drives will really take off.

Dorsey: And what's fascinating is you have this demand really increasing with smart phones and solid state drives, but there hasn't been a new factory that produces flash memory built in 18 months, two years?

Ng: It's been a year or two. There hasn't been much manufacturing capacity added at all. During the 2006-2007 timeframe, the flash memory industry added way too much manufacturing capacity.

So, in the last several years, they've been in a severe downturn. They've had no money to build out capacity. And so what you're seeing now is increasing demand, but limited capacity expansions.

Dorsey: And since this is pretty much a commodity industry, refresh me on Econ 101. When we have demand going up and pretty much no new supply.

Ng: Right. Pricing goes up.

Dorsey: Exactly.

Ng: And these flash memory producers do great.

Dorsey: And so if we have our forecast then, that flash prices are going to go up significantly, because you have no new supply on the market. And I think you mentioned that Toshiba announced that they're going to build a new fab. The announcement came today. But it's going to be what, 18 months, before that comes online?

Ng: Yes. Toshiba just announced a new fab. It's expected to come online spring of 2011. And we think that, right now, since there isn't much capacity, ultimately you'll have more players that will follow Toshiba's lead and start to add capacity, too.

Dorsey: And so if we think that flash prices are going to go up--it seems like a pretty strong thesis--an obvious play would be a company like SanDisk?

Ng: Yes, SanDisk. If you look at the flash memory producers, their stock prices tend to fluctuate with the industry cycle. So, since we think that prices are going to go up over the next several years, we think that, in the near term, SanDisk would be a good play.

Keep in mind, SanDisk isn't a stock you'd want to own for the really long term. Because, in the end of the day, flash memory is a commodity industry.

Dorsey: And also, SanDisk, we think it's only fairly valued right now.

Ng: Right.

Dorsey: And if we happen to be wrong about this, you're going to get utterly killed on buying SanDisk.

Ng: Right. It's such a volatile market. The stock prices, right now they're going up. We think things are going to do well. But if things were suddenly to turn around, SanDisk stock would drop like a rock.

Dorsey: Just get crushed, exactly. So the better way to play this then are a couple of companies that I've talked to you about several times, that actually build equipment that go to these fabs, or foundries, that make the flash. Kind of going down the food chain a bit. Tell me about a couple of those.

Ng: The picks and shovels. The guys that provide the picks and shovels, like Applied Materials, KLA Tencor. Those are two of our favorite chip equipment names right now. And, like I said earlier, we think that other flash memory producers will follow Toshiba's lead and build out new fabs. So, when they do, companies like Applied and KLA will benefit.

Dorsey: So it's kind of following a chain, right? Even if you can't make money directly on prices going up, because SanDisk is a risky investment, that price signal spurs more fabs to get built, which means you've got to buy equipment to make the fab.

Ng: Right.

Dorsey: And so, AMAT is kind of a one-stop shop for all of the chip equipment needs that a company might have. It's a good business. I think KLA Tencor might be a business that people are a bit less familiar with. And, in some ways, it's arguably a somewhat better company, which is in this sort of very protected niche. Tell me a little bit about KLA.

Ng: KLA is one of our favorite names in the chip engineering space. What they do is they make equipment called process diagnostic and control tools, which is used to look for problems during the chip manufacturing process. So, basically, their equipment helps improve chipmaker profitability by maximizing manufacturing yields.

Dorsey: And you've called this company, sort of you've mentioned it to me, as a software company disguised as a chip equipment company.

Ng: The secret sauce is really in the software and the algorithms that are in these PDC tools. So, KLA, they generate very strong cash flow like a software company.

Dorsey: And right now, the upside on the stock, based on where it is versus our fair value, our fair value is about 50% higher than the current stock price?

Ng: Yeah, that's right. Our fair value is $45 per share.

Dorsey: And so you'd expect that to play out kind of with increasing cash flows, over the next couple of years, as more fabs get built? And the chipmakers respond to these price signals.

Ng: Yes. As they respond and there's an upturn in the semiconductor space, we expect companies like KLA and Applied, we expect their stocks to go up.

Dorsey: Great stuff. Thanks for joining me, Andy.

Ng: Sure.

Dorsey: I'm Pat Dorsey and thanks for watching.