Lately, politicians of both parties are fond of repeating things so often that they believe them to be true. Lately, Micron Technology's (MU) VP of IR, Kipp Bedard, and CFO, Ron Foster, are guilty of the same thing with regard to the inventory valuation at their recent acquisition, Elpida. At Micron's August 9 analyst day, they promulgated the following outrageous myth about Elpida's inventory:
If you look at inventory it will be book[ed] to fair value for everything that was on the books, on the balance sheet as of the date of clos[ing]. So, that means that any value that was in the inventory at that time will flow through our financial statements effectively as zero gross margin. [emphasis added]
This sounds reasonable enough and has certainly been repeated by Kipp Bedard at investor conferences and by Ron Foster on earnings calls. It sounds good enough that some Wall St. analysts have even picked it up and dumbed down their margin assumptions in their research reports. The only problem is, it is completely and blatantly incorrect. It is the most glaring and concise and provable example of management's attempts to keep the lid on the stock price (more on this in the conclusion). I believe it may be a material misrepresentation of what is going on. Since I am long the stock and options, I guess I am less bothered by a misrepresentation that understates value than the other way around, although I am still miffed.
So how big a deal is this? On the 4q earnings call of October 10, 2013 the presentation slides showed Elpida's inventory value at July 31, 2013 at $772 million, plus a "valuation allowance" to mark this inventory to fair market value of $190 million, for a total of $962 million. In the 10k just issued, the consolidated inventory for all of Micron (including Elpida) just a month later stood at $2,649 million and total assets were $19,118 million. So Elpida's inventory (albeit 1 month previous due to Micron management's predilection to never give us current Elpida numbers) was about 36% of total consolidated inventories, and 5% of total consolidated assets. I'd call understating the value of an account of that size material.
What are the untruths and understatements? The first and only forgivable understatement is what has happened in the DRAM market, and of course management can't have known about the Wuxi fab fire that hit its competitor SK Hynix (OTC:HXSCL) on September 4th, a month after the Elpida acquisition finally closed and a few days after the end of the fiscal year. On September 3, the reference DDR3 2Gb DRAM chip traded at $1.588 according to DRAMeXchange. Today the spot price for the same chip was $1.967 -- an increase of 23.9% in just one month. While spot prices have ranged higher than that and have recently softened to this level, most analysts believe contract prices may now be 10%+ higher than they were before Wuxi. While Micron management can't have known that this would be a major disruptor to the company's "zero margin" myth, they would do well to spell out what Wuxi has meant for the business, and they have not.
The second component of the "zero margin" Elpida inventory myth is that all of the Elpida inventory was finished goods, and therefore was all marked up to fair market value as of the closing date. Of course, only a portion of Elpida's inventory was finished goods as the amended 8k details in note 5 on page 20:
|Work in Process||31%||26%||29%|
(Note this shareholder friendly company supplying a) stale information, and b) information with mismatched dates.)
Clearly only an average of 47% of the inventory on hand would be marked up to near (more on this below) fair market value. The other categories would not be sold at zero margin; they would enjoy Elpida's excellent margins to turn them into salable goods.
The final component of the "zero margin" Elpida inventory myth is that even the Finished Goods would be marked up to the point where they would be at zero margin. SA's own Retired Securities Attorney reminded me that chips in bulk in a warehouse will be at a lower price than chips in tubes or trays and nicely shrinkwrapped on pallets in lots of static resistant plastic on the customer's loading dock. This precis on purchase accounting from Deloitte explains the concept at page 53.
So show me the money! How big is this rock, and how big are the worms underneath? Let's assume some margins for the various components of inventory. This is pretty theoretical since Micron, as usual, provides little detail. Micron reported a consolidated 25% gross margin in its 4Q press release, which we can use as a starting point. This is pretty conservative when one considers SK Hynix's most recent quarterly margin of 41.7%, and Sandisk's (SNDK) 49.3%. Let's assume a 12% margin for finished goods: 10% for the Wuxi contract price hike and 2% for "selling effort" as Deloitte describes in the link above. Let's assume the Semi Finished Components get finished and go out the door with 10% incremental margin. The raw materials and supplies probably didn't go up much when marked to market and would get something like a full margin applied to them, but let's say 20%. And let's assume WIP gets an additional 15% applied to it. Based on the $962 million in "marked to market" inventory, and the historical average percentages of Elpida's inventory, as shown in the table above, here's the back of my envelope:
|Margin %||Margin $|
So instead of "inventory... flow[ing] through our financial statements effectively as zero gross margin" it looks like we can expect $121 million in gross margin on Elpida's inventory, or about $0.10 in earnings per Micron share!
Conclusion. This is but one of many rocks under which Micron is hiding earnings. Except this one is pretty nearly a quantifiable misdirection as shown above. Why would Micron do this? I can come up with a couple of reasons: a) it is clueless, b) Sanford Bernstein (see a previous article of mine) was correct that management might have wanted to keep things confused until their 2013 options grants were received -- now done, c) they don't want to ruffle feathers in Japan since they will be living with some court oversight as long as the installment debt to Elpida creditors is outstanding, or d) something bigger is about to happen.