$4.77 / www.lexarmedia.com / (LEXR-NASDAQ)
NOTE TO READER: THIS IS THE INITIAL REPORT; ALL NEW COMMENTS IN SUBSEQUENT REPORTS WILL BE HIGHLIGHTED.
LEXR’s fiscal year ends on December 31st. All calendar references are to the fiscal year.
Overview
Lexar is a leading manufacturer and marketer of award-winning removable flash memory cards, USB flash drives, card readers, and ATA controller technology solutions for the digital photography, consumer electronics, industrial, and communications markets. Lexar brands digital memory cards in the industry's most popular formats including CompactFlash, Memory Stick, Memory Stick Pro, MultiMediaCard, SD, Mini-SD, SmartMedia, and xD-Picture Card. Lexar's ATA controller solutions for industrial and OEM applications and its innovative intellectual property is licensed by some of the world's most respected companies. As a digital storage innovator, Lexar was the first to develop and advance proprietary read-write speed standards for its CompactFlash cards, and holds over 70 controller patents.
Lexar Media is taking on new cost cutting measures and restructuring in order to correct the business model and bring it back to profitability. The company’s focus more on premium products, in-house manufacturing of memory stick, and being less aggressive on pricing to focus on profitability over growth. In addition, the judgment against Toshiba could significantly change the company’s balance sheet as long as it is upheld. Therefore, a decision to invest in Lexar should depend upon your view of the overall health of the market for flash cards, as well as Lexar’s patent position and the future of the litigation with Toshiba.
Key Investment Positives / Key Investment Risks· A major victory in a patent infringement law suit against Toshiba
· Producing memory stick products internally rather than outsourcing in order to reduce costs.
· Substantial market-share driven by agreement with Kodak, a strong brand name. / · Falling profitability due to unexpected drop in product pricing.
· Competitive pressure in the tight NAND flash environment.
· Falling flash card ASPs and rising inventories will result in gross margin pressure.
Located in Fremont, California, Lexar design, develop, manufacture and market high-performance digital media as well as other flash based storage products for consumer markets that utilize digital media for the capture and retrieval of digital content for the digital photography, consumer electronics, computer, industrial and communications markets. The digital media products include a variety of flash memory cards with a range of speeds, capacities and special features to satisfy the various demands of different users of flash cards. To address the growing market for compact digital data and media storage solutions, the digital media products also include JumpDrive products, which are high-speed, portable USB flash drives for consumer applications that serve a variety of uses, including floppy disk replacement, as well as the line of digital music players, which are both portable MP3 players and storage devices. In addition, Lexar markets a variety of connectivity products that link its media products to PCs and other electronic host devices. Comapny also license proprietary controller technology and sell controllers to other manufacturers of flash storage media.
The jury in Toshiba litigation trial ruled in favor of Lexar and awarded monetary damages of $381M. The jury found Toshiba guilty on two charges 1) Misappropriation of trade secrets and 2) Breach of fiduciary duty and awarded the damages accordingly. Of the 10 LEXR claims, Toshiba was found to have violated 7 trade secrets. As such, LEXR received $255.5M on the basis of “unjust enrichment” by Toshiba Corp. Breach of fiduciary duty charges resulted in a $58.7M award from Toshiba Corp and $58.7M from TAEC (totaling $117.4M) plus $8.2M in interest. As for punitive damages on breach of fiduciary duties, the court is expected to reconvene and hear arguments from both sides. The benchmark used is the monetary damage, which in this case is $117.4M (2x$58.7M). Thus, analysts expect punitive damages to equal at least the monetary damage with possibly as high as a 2-3x multiple of that. Analysts believe the $381M in monetary damages combined with potential punitive damages should bring in an additional $6-$7 per share based on $381M + $234M-$350M (2-3x $117M) on 90M fully diluted shares (discounted back to present value at 10% discount). With a potentially stronger balance sheet, analysts believe survival and liquidity may no longer be an issue. If Lexar prevails against Toshiba through the appeals process, there is a possibility that a subsequent court award or settlement injects significant cash into Lexar's business, or gives rise to a high-margin licensing business. Analysts believe that either might be reasons to become more constructive on Lexar's prospects.
The stock has recently started to falter as growth in digital camera sales has also slowed following rapid uptake over the past few years. Further, a slow down in growth of mega pixels per picture has contributed to the slowing demand for additional storage. The industry hopes that growth in the use of flash memory in other products, such as wireless handsets and digital music players, will take up the slack in demand. An increasing number of handsets are coming with slots for flash cards as gaming, pictures, video and other applications gain popularity.
Key Dates
April 14, 2005 FQ01 earnings release
Sales 203 millions, EPS (0.16)
Sales
Annual Estimates / Quarterly Estimates12/2005 / 12/2006 / 03/2005 / 06/2005
Most Recent Consensus / 919 / / 1087 / 203 / / 215 /
Zacks Consensus / 925 / / 1108 / / 203 / / 215 /
Lexar derives revenue primarily from two segments — Products and License and royalties. Lexar generate revenues primarily from the sale of digital media and connectivity products to end-users through mass market, photo and OEM channels. Since the beginning of 2002, the company has significantly increased its presence in the mass-market channel by increasing the number of retail storefronts. LEXR’s products were sold in more than 65,000 retail stores worldwide at the end of 2004, which represents an increase of approximately 23,000 storefronts from the end of 2003 and an increase of approximately 34,000 storefronts from the end of 2002. Digital media sales comprised 96.9% of the gross revenues for 2004.
Lexar also generates revenue from the sales of flash memory controllers. The company derives license and royalty revenues from several licensing agreements, with Samsung being the primary contributor. License payments from Samsung are variable, based on volume of production and sales, relative market share, and aggregate purchases by Lexar. Since March 31, 2004, variable-based royalties from Samsung under this agreement have been minimal, and company expects that trend to continue for the foreseeable future. License and royalty revenues from all licensees were approximately $7.1 million during 2004. Lexar is actively working to license its technology to other companies.
Starting in the fourth quarter of 2004, Lexar changed the timing of recognizing revenue related to all resellers now on a sell-through basis from a sell-to basis. This had the initial one-time effect of reducing net revenues recorded in the fourth quarter of 2004 by $63.6 million.
Total fourth quarter revenues of $188.5 million after the change in estimate, increased 6% from $177.5 million in the same period last year and increased 14% sequentially from $165.2 million in the preceding quarter. Product revenues of $187.4 million increased 8% from $172.8 million in the same period last year and increased 14% from $164.1 million in the preceding quarter. Revenues for the year ended December 31, 2004 were $681.7 million after the change in estimate, a 65% increase from $412.3 million for the year ended December 31, 2003. Product revenues of $674.6 million for 2004 increased 71% from $394.6 million for 2003.
Product Revenue: Increased sales of flash memory products in the retail channel were the major factor for the significant growth in the product revenues in 2004. Increased sales into the retail market continued to boost in total sales with very strong seasonal consumer demand during the holiday season. Lexar experienced a 54.4% increase in digital media units sold in 2004 compared with 2003, due to increased demand in the retail and OEM channels and a 45.5% increase in average capacity per digital media unit sold. These increases were offset by a 44.2% decline in the average gross selling price per megabyte of digital media. Lexar is now trying to ensure that their pricing strategy going forward reflects the intention to focus on profitability. The company has significantly reduced promotional programs and increased prices on certain products to most of its customers to better align the selling prices with the cost structure. In addition, Lexar is planning to emphasize more of its premium products, which have higher margins. In 2004, Lexar derived 59.0%, 22.6%, 3.0% and 15.4% of the product revenues from sales to customers in the United States, Europe, Japan and the rest of the world, respectively.
License Revenue: Lexar generates license and royalty revenues primarily from the agreement with Samsung under which the company licensed the use of its intellectual property. The license and royalty revenues decreased from $17.7 million in 2003 to $7.1 million in 2004, due to license and royalty revenues from Samsung becoming variable in April 2004. The company expects license and royalty revenues to decline in 2005 if the company is unsuccessful in licensing the intellectual property or recovering license and royalty revenues from third parties who are infringing the patents or under-reporting royalty revenues.
Sales estimates for FY2005 range from $760.3 million (Unterberg Towbin) to $941.5million (WR Hambrecht). The analyst at the low-end for FY 2005 (Unterberg Towbin) believes that in the recent months, LEXR has suffered financially as a result of the increasing competitive retail pricing and shift towards higher density products. Analysts believes LEXR needs to recalibrate its operating model by becoming more competitive on the retail pricing front and the analyst at the high-end of estimates (WR Hambrecht) believes Lexar saw a major win in its Toshiba litigation case and is going through a restructuring plan in which the company will focus more on profitability rather than market share.
Margin
The cost of product revenues increased in 2004 primarily as a result of 54.4% increase in the number of digital media units sold, due to increased demand and a 45.5% increase in the average capacity per digital media unit sold. In addition, costs of revenues in 2004 were impacted by an increase in inventory valuation reserve of $15.8 million. These factors were partially offset by a 30.3% decline in the average cost per megabyte of digital media sold in 2004 compared to 2003. These factors contributed to a significant decrease in gross margin for 2004. With a potential positive outcome of the patent infringement case against Toshiba, analysts believe that Lexar’s gross margin could reaccelerate from a stronger patent position.
Research and development expenses for 2004 increased as compared to 2003 primarily due to the $1.5 million increase in compensation expenses. Though hiring of additional personnel was the primary factor, the cost also spiraled due to purchase of project material of $1.0 million and new product development initiatives including controllers for new flash memory types and form factors as well as new flash products.
The increase in sales and marketing expenses was due to increased sales, which resulted in an increases of $12.8 million in freight and fulfillment expenses, $7.8 million in market development expenses, and $6.3 million in compensation expenses. Legal expenses in connection with the ongoing litigation and a $2.9 million increase in costs associated with regulatory requirements related in part to compliance with Section 404 of the Sarbanes-Oxley Act of 2002 is the main cause for the increase in general and administrative expenses.
Consensus Margins2003 / 2004 / 2005E
Gross Margin / 25.6% / 5.4% / 11.5%
Operating Margin / 10.8% / -10.7% / -4.7%
Net Margin / -11.1% / -5.4% / 1.6%
Earnings Per Share
Annual Estimates / Quarterly Estimates12/2005 / 12/2006 / 03/2005 / 06/2005
Most Recent Consensus / -0.19 / / 0.37 / -0.16 / / -0.06 /
Zacks Consensus / -0.14 / / 0.43 / -0.17 / / -0.08 /
Zacks Most Accurate Forecast / -0.49 / / 0.55 / -0.25 / / -0.18 /
For the December quarter, LEXR reported EPS of $(0.80) compared to EPS of ($0.04) during 3Q04. Analysts believe a direct comparison to past performance is difficult due to a change in sales recognition from a “sell in” to basis to a “sell through” basis. Guidance for 1Q05 is for EPS ($0.14)-($0.16) on sales of at least $200 million. Excluding legal costs guidance for EPS is ($0.02) - ($0.06).
Estimates for FY 2005 range from $(1.13) (Unterberg Towbin) to $(0.14) (SG Cowen). The analyst on the low-end for FY 2005 (Unterberg Towbin) is neutral on the stock and the analyst though on the high-end for FY 2005 (SG Cowen) believes that appeals and a separate patent case could take a year, with a return to profits uncertain and roughly $0 net cash, analyst expects the stock to drift lower.
Target Price/Valuation
Only two brokers quote target prices for Lexar. One analyst (RBC Cap.) has a $4 target price and the other analyst (CIBC) with a $7 target price. The analyst on the high-end (CIBC) $7 price target is roughly in line with the value of LEXR’s tangible book ($2.25 per share) plus cash per share from the Toshiba litigation, $4.87, or the present value of a conservatively estimated $500M award, discounted by 18 months or the expected length of appeal. The other analyst (RBC Cap.) believes a 1x multiple of tangible book is appropriate, given that tangible book value is the liquidation value of the stock, that Lexar is currently unprofitable, and that there exists considerable uncertainty regarding Lexar’s strategic direction.