Shares of Micron Technology (MU) can't wait for the first quarter earnings report to be released next week. Investors are heavily debating and wondering the true impact of higher DRAM pricing and the acquisition of Elpida at the run rate of the business in terms of revenues, but of course in terms of earnings as well.
The "fair" value range in this stock is very wide given the uncertainty. With no convincing arguments to either the far upside or far downside, I remain on the sidelines awaiting next week's report.
Bank Of America Turns Cautious Ahead Of Next Week's Earnings
At the start of last week, Micron Technology received a downgrade from analysts at Bank of America/Merrill Lynch. Analysts at the bank downgraded the stock from "Neutral" to "Underperform", accompanied by a $19.50 price target. Compared to the $22.17 share price level before the report has been issued, the target represents some 12% downside potential.
Analyst Dong-Je Woo believes the stock is least preferred in memory seeing weakness on the back of DRAM spot prices falling on increased supply. This is witnessed among others by the competitive threat of SK Hynix, which is trying to construct a new factory.
SK Hynix To Destroy The Bull Run?
Ahead of the analyst report last week was a story ran by Bloomberg saying that South Korea's SK Hynix (OTC:HXSCL) will build a new DRAM factory in 2014, adding already to capacity in 2015. Shares of Micron fell nearly 5% that day in the wake of the report, after trading with losses of over 9% intra-day.
The huge run up in Micron's shares, with shares up roughly 240% for 2013 alone, is largely contributed to a supply shortage of chips, allowing the firm to ask high prices. Any signs of a price decrease, on the back of supply hitting the market, could hurt the short term prospects for the shares considerably.
It is worth nothing that not all analysts are cautious on Micron following these news stories. Raymond James continues to hold a "Strong Buy" rating. A potential $4 billion facility would only equate to 5% of DRAM supply according to analysts, not making it a major move, while supply won't hit the market until 2015. Piper Jaffray agrees with Raymond James, believing that Samsung (OTC:SSNLF), Micron and Hynix will continue to keep DRAM supply rational.
This Year's Performance And Balance Sheet
Back in October, Micron released its fourth quarter results. The company ended the quarter with $3.10 billion in cash and short term investments. It is noteworthy that the company holds another $1.05 billion in restricted cash and long term marketable securities. Total debt stands at $6.04 billion, resulting in a net debt position of close to $3 billion which is quite sizable.
Revenues for 2013 were reported at $9.07 billion, up 10.2% compared to 2012. The company posted a $1.19 billion gain compared to a $1.03 billion loss last year. Note that earnings were massively aided by a $1.48 billion gain on the acquisition of Elpida.
Trading at $21.50 per share, the market values Micron at $22.8 billion. This values equity in the company at 2.5 times annual revenues for the past year. The valuation comes down to roughly 1.5 times annual revenues as I foresee revenues of around $15 billion going forwards. The company does not pay a dividend at this point in time.
Looking At Micron's Past Performance
Shares of Micron peaked at levels in their '80s during the internet bubble around the turn of the century. From that moment on it was all downhill with shares falling to lows of $2 in 2008. Shares started the year only around $7 but after the very strong momentum this year, they are currently trading around $21.50.
Between 2010 and 2013, Micron has increased its annual revenues by a cumulative 7% to $9.07 billion. After reporting earnings of $1.85 billion in 2010, the firm reported steep losses in 2012. Even as the company posted solid earnings in 2013, these were entirely the result of the Elpida acquisition, with the firm still operating with a small operating loss for the full year.
Recommendation For Investors
It seems that everyone is waiting for the first quarter earnings report, scheduled for next week. Only then will we know the real impact of the acquisition of Elpida. Note that the fourth quarter earnings release of 2013 only included Elpida's contributions for a month.
As such I estimate that fourth quarter revenues for Micron were about $2.5 billion excluding the one month contribution of Elpida. Adding a quarterly revenue run rate of $1.0-$1.1 billion for Elpida and a little growth to that number, and I see first quarter revenues between $3.5 and $4.0 billion. This implies annual revenues $14-$16 billion on an annual run rate.
Note that earnings will be a whole different story. Gross margins for Micron were about 25% for the fourth quarter, while those of Elpida are seen around 50%. As such, gross profits around $600-$700 million for Micron and another $400-$600 million for Elpida are possible. As such I arrive at potential gross profits of $1.0-$1.3 billion. This guidance is based on revenues coming in at the low end of the revenue guidance. If revenues would come closer to $4 billion on the back of temporarily higher revenues, gross profits could increase by roughly a third of the incremental higher revenues.
Now let's subtract the guided costs for the quarter to this number. SG&A is seen around $185-$195 million, R&D expenses at $340-$350 million while interest payments are seen between $75 and $85 million. Guided costs therefore come in around $615 million, suggesting earnings of roughly $400 to $700 million before taxes. Note that Micron's effective tax rates have moved around a lot in recent years, but let's use a ballpark figure of 20%. This results in annualized earnings between $1.7 and $2.2 billion after tax.
This would roughly translate into earnings of $2 per share in somewhat normalized conditions. Given the lower potential tax rates in the short term, and potential for peak revenues on higher prices in the short term as well, it might be possible for Micron to report earnings of around $3 per share. Yet I do not belief this would be very sustainable.
Even $2 per share sustainable earnings might not be sufficient, as these kind of peak earnings would attract competition. I am not really convinced about arguments that the three players in DRAM being Micron, Samsung and Hynix will create an effective oligopoly. Reliance on these assumptions can be very dangerous, just ask any potash investor over the past year.
I want to stress that I don't have any position now in the stock, nor did I have one during the entire year of 2013. Therefore I truly congratulate investors who have had a great ride this year. Yet I see a lot of guys pushing for further potential, based on the arguments of strong pricing and consolidation, which seems a bit stretched and dangerous in my opinion. This kind of bullishness underestimates the potential impact of competition or technological changes.
As Micron has positioned itself pretty nicely around the mobile ecosystem, a valuation at 10-12 times earnings which are sustainable seems sufficient enough in my opinion. I would argue that "sustainable" earnings at this point in time are around $2 billion, leaving little potential at today's valuation. For this reason I will not either initiate a long or short position, but remain on the sidelines. Yet I will be very interested to see how the first quarter earnings report plays out next week.