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Shares of Micron Technology (MU) took a serious beating on Friday after Wells Fargo issued a bearish research report on the firm. Shares fell nearly 9% as the bank cut Micron to underperform.

I think the cautiousness is warranted as the market has become too enthusiastic on Micron's prospects on the back of the Elpida deal and high spot DRAM prices. I remain on the sidelines for now, not seeing any compelling value in initiating either a short or long position at current levels.

Well's Fargo Is Becoming Cautious

Analyst David Wong downgraded Micron from "Market Perform" to "Underperform." Wong notes that Micron reported its first-quarter earnings report following the Elpida acquisition, giving it much needed information to model the effects of the deal.

The bank increased the EPS estimate from $1.00 per share to $1.24 per share for 2014, while introducing a $1.30 per share estimate for 2015. While Wong raises the valuation range from $11-$14 to $14-$17 on the back of this, the range remains below Micron's share price at the time of the report, warranting the "underperform" rating.

The new valuation range is based on a 11-13 times multiple for 2015 estimated earnings. Risks to the valuation range include volatile pricing of DRAM and NAND flash, high capital investment requirements and likely large profitability swings.

Shares of Micron traded around $18.50 on Thursday's close, suggesting there is some 16% downside toward the midpoint of the revised value range. On the back of the report, shares are currently trading around $16.50 on Monday.

Valuation

Micron Technology ended its fourth quarter with $3.10 billion in cash and short-term investments. The company furthermore holds $499 million in long-term marketable securities. Total debt stands at $6.04 billion, resulting in a net debt position of roughly $2.4 billion.

Revenues for the fiscal year of 2013 came in at $9.07 billion, up 10.2% on the year before. The company turned a $1.03 billion loss into earnings of $1.19 billion. Note that earnings were entirely driven by $1.48 billion accounting gains resulting from the acquisition of Elpida, closing in July.

Trading around $17 per share, the market values Micron at $17.6 billion. This values operating assets of the firm at 1.9 times annual revenues and roughly 17 times earnings.

Micron Technology does not pay a dividend at the moment.

Some Historical Perspective

Over the past decade, shareholders in Micron have seen nothing except great volatility. Shares traded in a $10-$18 trading range between 2004 and 2007 to fall to lows of just $2 in 2009. As a matter of fact, shares only traded at $5 by the end of 2012 to witness spectacular returns towards highs of $19 in recent weeks.

Between the fiscal 2010 and 2013, Micron has increased its annual revenues by a cumulative 7% to $9.1 billion. After reporting large losses last year, Micron returned to profitability in 2013, although driven by purchase accounting effects.

Investment Thesis

Expect more volatility ahead as the investment community is still trying to figure out the real impact of Elpida's deal on Micron's operations.

The deal was finally closed on July 31, which means that the operations contributed for one month into Micron's fourth-quarter earnings. Micron reported fourth-quarter revenues of $2.84 billion, including $355 million in revenues from Elpida being generated in the month of August. Operating income totaled $207 million, while Elpida added $29 million in net income, according to Micron's fourth-quarter release.

As such, Micron's own operations generated quarterly revenues of $2.49 billion, at a rate of $10 billion per annum. Annualizing Elpida's monthly contribution implies another $4.3 billion in annual revenues. Now add to that the fact that DRAM prices are strong in the first quarter, and Micron should be able to generate revenues at an annual run rate of over $15 billion at the moment.

Following a similar calculation for operating earnings, Micron should be able to report operating earnings anywhere between $1-$2 billion per annum now, factoring recent price hikes. Analysts at Wells Fargo see 2015 earnings around $1.30 per share, or around $1.3 billion, which seems fair in this light.

While other analysts, including Jefferies' Bajikar are more optimistic, this is largely driven by expected short-term momentum in sport prices driven by a fire at SK Hynix, causing DRAM spot prices to jump in September. Jefferies actually has a $30 price target, believing DRAM capacity will be structurally limited. While the tie-up between Micron and Elpida has created the second largest DRAM chipmaker behind Samsung, and gives Micron more pricing power, I don't see structurally limited capacity in an historical volatile industry.

Note that Micron's earnings could see a huge boost for the short term on those booming prices, but extrapolating those earnings into the future could prove to be a costly mistake, even as DRAM average selling prices are seen up between 5 and 7% compared to the fourth quarter.

So for the short term Micron will see two huge tailwinds. Integration benefits and high spot prices will boost earnings into 2014. When the market normalizes, the historical earnings volatility should be reduced given the concentration within the sector. As such I like both Micron's short- and long-term prospects. Yet even when attaching a 10 times through the cycle multiple to earnings between $1.5-$2.0 billion, I don't see much potential, at least not passing my margins of safety.

As such I agree more with analysts at Wells Fargo at the moment, and would remain very cautious. Very strong momentum this year has already priced in the great benefits from the Elpida deal.

I remain on the sidelines, not seeing great potential to initiate either a short or long position in the shares.

Source: Micron Technology - Wells Fargo Is Cautious, And I Must Agree