When Micron (MU) reports its FY 4Q results on October 10th, the audience will likely be larger than usual. In addition to shares being up 167% year-to-date, this marks the first earnings call post-Elpida acquisition and post Hynix's factory fire. While analysts are sure to ask typical questions regarding margins, demand, channel inventory, accretion from Elpida, etc., we believe answers to the 4 questions we pose in this article will help determine whether at current levels, shares currently represent a good investment or an outstanding one.
When we recommended Micron shares last November with the stock trading at $5.71, our premise was that DRAM variable manufacturing costs exceeded selling prices which was an unsustainable situation, and precisely the time to go long. We were right, and as often occurs when you buy a cheap stock at cycle bottom, unanticipated developments emerge that enhance the story. In our view, barring a macro-implosion, if Micron management stays focused on ROI, shares could still conceivably double from here. Below are 4 questions that we think would go a long way to determining the trajectory of Micron - as well as our thoughts surrounding them.
1) Does the Hynix fire change your thinking regarding FY14 cap-ex or cap-ex spending in the future?
We hope and expect that Micron will state that the fire does not impact its thoughts on spending. A new fab is a multi-billion dollar, multi-year project. While the Hynix fire will impact supply and ASPs for the duration of FY14, it does not merit a change to spending. That Micron management believes this is extremely important. Every memory industry downturn in the last 2+ decades has been induced by supply additions. Demand will not be the problem. If supply stays disciplined, it will be clear sailing for Micron longs.
An amazing aspect of the Hynix fire is how pronounced its impact has been on pricing - spot is up ~40% and contract up 20%. Assuming the Wuxi fab represents half of Hynix' output, or roughly 12% of global DRAM supply and a worst case of it being totally off-line for 6 months (more likely not quite 12% and slightly less than 6 months), that would mean DRAM output is reduced by worst-case 6% on an annual basis. (If this draconian scenario happens, chip prices likely rise further). The point is, a potential 2-6% industry shortfall is having a huge impact on industry ASPs.
However, it's notable that over the last couple of decades, it's been only moderate excess DRAM supply or shortages that have resulted in dramatic changes in ASP. DRAM demand is notably inelastic - new applications just don't open when price falls, in stark contrast to NAND flash, for example - so even in years with single digit percent excess supply, the industry has observed ASP declines of 30% or more (the memory industry is littered with the remains of bankrupt companies). Conversely, a relatively modest tightening of supply can have a dramatic, positive impact on pricing. Which leads to the following question:
2) Would you consider slowing production in certain environments?
We believe that for the first time in memory industry history, there are occasions where it might make sense to run operations more slowly (other than in periods of desperation).
Historically, with more industry players and significant market share fragmentation, reducing output would be self-defeating. Now, there are occasions when a unilateral decision to cut output could be beneficial.
Imagine some time in the future if Micron management didn't like memory industry supply/demand dynamics. It said "we're going to slow output by 10%" - thereby reducing industry supply by ~3%. Such a move could increase pricing by 10% or 20% or more. Certainly Hynix and Samsung would benefit, but so what? This is no longer a market share game - ASPs equal profits. And as we've written previously, Samsung (OTC:SSNLF) has little incentive to do anything but keep pricing up.
Slowing capacity adds, furloughing facilities, and granting extended vacations are things we've observed in numerous other industries to enhance profitability - albeit usually in times of desperation. In this new DRAM oligopoly, we believe the leverage firmly is in the hands of the suppliers. We certainly believe that famed value investor Seth Klarman/Baupost bought over 41 million shares of Micron because this time it's different.
3) How would you prioritize buybacks versus dividends?
Micron will likely generate enormous free cash flow in FY14 and beyond. Based on analysis by fellow SA author Electric Phred, he very reasonably posits that Micron will generate between $2.8 and $3.2 in free cash flow in FY14. Notably, this article was published based on comments from Micron IR from September 3rd - a day before the Hynix fire. We estimate the fire's impact may increase FCF by $700-$800 million. Specifically we believe DRAM ASPs over the next 12 months will be 10% better than previously expected. On approximately $10 billion of combined MU/Elpida DRAM, that adds $1 billion, with no incremental expense, or likely $700-$800 million on an after tax basis (or roughly $0.67-$0.78 to Electric Phred's $3.50 EPS estimate).
Micron management will likely comment that they need to buy back convertible debt, so returning capital is not a priority. However, we would like to know philosophically, if there was no debt to reduce, how they feel about buybacks versus dividends.
We are big advocates of repurchases - we are, as far as we know, the first pundits to suggest Apple (AAPL) massively lever up for a record breaking share repurchase program (multiple quarters before Einhorn and Icahn asked Apple to do so) - so clearly, we like buybacks when shares are intrinsically undervalued.
The fact is, if Micron is going to generate $3-$4 billion in free cash flow, and has an equity value of $17-$18 billion, it would represent a free cash flow yield of 17-24%. If these estimates are off by $1 billion, shares are still ridiculously cheap on an FCF yield basis. Management would be insane to suggest anything other than a massive buyback at current prices. We'd suggest that when the return of capital story become more apparent, the stock will ascend to a far higher level. Given the significant stock option grants Micron has historically provided top management, they certainly have the incentive to do the right thing.
4) At what price are you a seller?
We assume in the last question, that at current prices management will use excess cash to repurchase stock. There is a price where they would not only opt to not buy stock, but where they would sell the company, if an offer existed. We certainly don't expect management to reveal the magic number, nor do we think Micron is in play; however, given its likely EBITDA and FCF generation, we think the potential for a buyout has to enter the discussion.
We think the analogy to the hard drive industry is particularly apt. In 2000, Seagate (STX) was taken private. It re-listed in 2002. If Micron remains at current levels and generates the numbers we anticipate, there is no reason a financial buyer wouldn't take a close look at the company. In our view, this puts a substantial floor on shares. Moreover, the longer Micron, and the memory industry as a whole, remain disciplined, the more that financial buyers will be interested in the space, particularly if Micron remains undervalued.
Of course, the wild card - and we admit this is a major wild card - is the possibility that Apple would consider acquiring Micron. While this might sound somewhat outrageous, we believe that it actually makes sense. Apple has ample and excess cash. Even at $30 billion (roughly $28 per share), Apple would likely pay under 5% on debt, meaning $1.5 billion per year interest on $3+ billion FCF or ~$1.50 of accretion. On a strategic level, it would put Apple on an even footing with Samsung, which benefits from its internally sourced memory. Moreover, it would pressure the myriad low-cost competitors who are competing on price, particularly in emerging markets.
We remain firmly positive on Micron and the difference from here regarding good and great is in management's hands; simply put, capital discipline.
As an additional play on our positive view on memory, we recommend investors look at ChipMOS (IMOS), a previous Alpha-Rich pick. Shares trade for under 3x EV/EBITDA, and offer a near 20% free cash flow yield. Micron is their 2nd largest customer and has grown revenue at ChipMOS each of the last 3 years (even down years for Micron). While LCD driver-ICs were the sexy part of the story, in a new, stable world for memory, a former tailwind could quickly become a headwind. Not coincidentally, Baupost became ChipMOS's largest shareholder in 2Q. With a solid 4Q and 2014 outlook likely, and our expectations of a major buyback announcement (at least $30 million+) before year-end, we believe longs are likely to see a 50% return before the clock strikes on 2014.
Additional disclosure: We conduct thorough research on our ideas, but our views are our own. Please do your own research.