In this article I try to explain some theories on why Micron (NASDAQ:MU) will not reach $40 in calendar year 2014. These are just theories that rely mostly on my nurtured logical intuitive predictive ability - most people would just say they are guesses - but I'm an engineer . . .
In my first and latest Seeking Alpha article I described Micron as providing memory for the Gold Rush. Providing memory for the high tech "Gold Rush" was a huge point in the February 7, 2014 Micron Analyst Day presentation. The slides from the presentation especially slides 7,29,38 and 53-74 focus on the huge growth in demand for memory throughout the technology industry (think Gold Rush).
Doubling of Demand over Next 3 to 4 years
Slides 54 and 60 from the Analyst Day presentation show demand for both DRAM and NAND memory doubling over the next three to four years! This is likely conservative as more and more uses for memory are implemented.
Wait! Mark Durcan (CEO) was very clear that he did not see the need for any new fabrication facilities in the foreseeable future. So how can Micron meet this increase in demand for memory?
First it is important to realize that Micron describes memory demand in terms of bits of memory. Technology improvements are going to allow Micron to make memory that will hold more bits of memory per wafer of silicon. While this technology growth has slowed somewhat in recent years, Micron is still making progress. In addition, Micron can make incremental improvements to its existing facilities to increase production like adding a clean room, replacing older equipment with newer more efficient equipment or putting more equipment inside an existing building.
These types of actions to increase memory production are very cost effective and significantly lower the cost of making memory. These cost effective actions also allow Micron to remain competitive.
In addition Micron continues to collaborate with numerous high tech companies to customize memory and accompanying controllers to meet the specific needs of memory users - allowing for higher Micron margins. The end result is more memory that costs less per bit to make and commands a premium price - read this as higher profits and earnings!
Micron "Should" be at $40 by April 2014
A recent Seeking Alpha article by Russ Fischer laid out the case for earnings of $0.95 per share at the March/April earnings report. In comments SA "Retired Security Attorney" describes his basis for earnings of $1.17 to $1.21 per share - Russ agrees - Russ had notched back his numbers so his estimates would not be as much of a target.
Micron CFO Ron Foster during the Analyst Day presentation pointed out that the consensus of analysts assign SanDisk a price to earnings (P/E) ratio of 11.9 and they assign Micron a lower P/E ratio of 8.6. Using a conservative and simple $1 per share earnings for this quarter and a concomitant annual $4 per share earnings, these two P/E ratios yield a stock value range of $34.40 to $47.60 with a midpoint of $41 by April 2014.
"Should" vs. Reality
Reality in the stock market is a function of perceptions. To look at "should" vs. reality we need to review perceptions in the Market:
- Micron is a cyclical stock. In the past the stock price rose rapidly and then declined about a dozen times over the last 20 years. That's quite a record to overcome.
- If another company builds new memory capacity, Micron stock will fall. As Hynix comes back on line from its 2013 fire, Micron stock will drop.
- Micron has increased so much over the last sixteen months - it will drop. In October 2012 Micron stock price was $5.17/share. On February 7, 2014 the price was $24.51 . . . a 474% increase!
- Micron has a high debt ratio with a high interest burden which makes it especially vulnerable to earnings drops in downturns.
- Micron management is not very clear in giving guidance. Management talks about percentage increases and decreases in costs and revenue but do not provide guidance for earnings. It takes a lot of knowledge and background to develop earnings estimates from Micron "guidance."
All of these factors hold Micron stock price down. Let's examine each.
The key phrase here is that the memory business is different now. In the past cycles were dramatic for two main reasons:
- World governments like Korea and Japan wanted to get into the memory business and funded/subsidized new fabrication facilities increasing production and destroying profits.
- Technology improvements allowed memory producers to double production of bits without increasing wafer fabrication facilities - again flooding the market with memory.
You can imagine the impact of doubling wafer fabrication capacity and at the same time doubling how many bits of memory could be produced from a single wafer - memory companies went bankrupt and were sold at distressed prices!
NOW: As shown in the Micron Analyst Day presentation, memory makers are consolidated into five main memory makers and only two - Samsung (OTC:SSNLF) and Micron - produce the full spectrum of NAND, DRAM and NOR memory. These memory makers also own almost all of the patents for making memory.
New Memory Capacity
A new memory fabrication facility would cost $3 to $5 billion and the new manufacturer would need to "buy" the right to use patents. Then the facility would likely be out of date by the time it was brought on line. Existing chip production companies that make processors could cost effectively convert old facilities to memory production but they would need patents . . . and why take on memory production risks and headaches when Micron collaborates with companies to meet their specific memory needs (see Analyst Day presentation)?
Besides Samsung's new NAND facility in China ($7 billion), no other memory manufacturer has announced plans to build new memory capacity. It appears that there is plenty of demand for memory as Samsung ramps up production of NAND which they indicate will be focused on mobile phone use in China.
There has also been a lot of noise about Hynix bringing back on line memory capacity and how that memory capacity will bring down memory prices. Memory production requires extremely clean facilities to produce high quality memory. Think about how smoke damage is usually much worse than fire damage. That is especially true with memory clean rooms. Hynix is now producing just as much memory as before the fire but the memory has a lower quality due to ongoing problems related to smoke damage. Hynix is building a new clean room to address the issue but the new clean room will not be on line until 2015 . . . and demand for memory is continuing to increase.
NOW: No company, except Samsung, has announced plans to build new memory fabrication facilities. Micron has indicated that new memory fabrication facilities are not financially feasible at this time. There is plenty of demand for memory to fit with the announced memory capacity.
Past Increases in Micron Share Price
"What goes up must come down" comes to mind. How about the US debt? Let's not go there . . .
Many people that have made fortunes in stock use the theory that a strong company in a strong industry that is going up in value will continue to go up in value. Do not underestimate the power of momentum. These successful investors do not buy low and sell high. They buy high understanding that the industry and company are well positioned to keep the stock going higher.
NOW: Micron has gone from $5.17 to $24.51 in 16 months, has demonstrated sound management and is very well positioned in a growing and consolidated industry. The stock price will continue to increase to $40 and beyond.
During the rough years, Micron accumulated significant debt to stay in business. Because their financial position was not strong (poor bond ratings), they were forced to borrow using convertible bonds that essentially shared increases in stock value with bond holders as a way to get them to loan money to Micron.
NOW: The debt that Micron took on with the purchase of Elpida is interest free! Micron management has been and will continue to refinance their debt to get out from under as much convertible bonds as they can. Management has been able to improve their bond rating recently and as a result they have sold non-convertible bonds to refinance convertible bonds. Their stated goal is to reduce the debt ratio from 0.63 to 0.25.
Lack of Clear Guidance
I must admit that the lack of clarity by Micron management at first was very frustrating for me. Then I realized that their collaborations with numerous technology companies did not allow for Micron management to share much information - hardly anything - especially when agreements with the likes of Apple specifically forbid sharing anything about agreements.
Another reason for lack of clarity was the complex purchase accounting associated with the deal-of-the-decade purchase of Elpida. First it was complicated to make the calculations and then there were several potential complications over the 18 month purchase period.
NOW: Micron is much clearer overall in describing the direction of the company as demonstrated in their Analyst Day presentation. I have also realized that hidden information is a great opportunity for investors with the help of better-than-analysts SA contributors like Russ Fischer, RSA, Phred, etc. These guys can understand the scanty information provided by Micron management and estimate with astounding accuracy future earnings (when "analysts" fail miserably).
Management Not Ready for Huge Increases in Stock Price
Why will Micron stock not reach $40 in 2014? As described above "guided" earnings point to stock pricing of $40 and beyond. What will hold it back? The simple reason is that Micron management is not ready for the increased stock price.
Sure the perceptions discussed above are factors in why Micron stock price is not rising faster in line with earnings. But let's follow the money related to the following:
1. Management stock options
2. Insider trading
3. Refinance of convertible bonds
Management Stock Options
Micron management like in many other companies receives stock options in addition to salaries. Theoretically, these options are to encourage management to work hard so the stock goes up in value. Practically, it does not always work that way. First it is important to understand the management stock options are not like stock options that you and I buy. Their stock options often last many years (6 to 8) before they need to exercise them. This tends to give management a long-term view of the value of the stock - which can be good.
Management stock options are kind of like the reverse of income taxes - both stock options and income taxes tend to push people to arrange their financial affairs in specific ways. With income taxes, income and investments are arranged in a fashion that minimizes taxes. With stock options, management arranges the affairs of the company to maximize the long-term value of the options.
Management can do the following to increase the long-term value of stock:
- Refinance convertible bonds (see Debt above and discussion below)
- Provide information that builds long-term confidence in the company (e.g., see Analyst Day presentation regarding increasing demand, technology advances, etc.)
- Arrange financial information to avoid spikes and drops in earnings to provide a strong track record of consistently increasing earnings. This specifically addresses the market perception that Micron is cyclical. Examples include:
- All of the $280m Rambus settlement costs were accounted for in the 1st quarter instead of spreading it over several years as management could have done.
- Purchase accounting required that inventory be booked at current values so that future earnings were lower until the inventory was sold.
Result: Management is focused on arranging financial affairs to achieve consistent long-term increases in stock prices - not short term. This approach will ultimately increase Micron stock price higher than inconsistent short-term spikes in earnings.
Insider sale of stock in relatively small amounts tends to keep stock prices down because the market perception is that these insiders must think the stock price is going to go down or else they would not be selling.
As others have said there are many reasons why managers sell stock including:
1. They use the money to exercise options or pay taxes associated with options
2. Divorce settlement
3. After many years of no benefit from stock options they want to enjoy life a little
4. College for the kids
5. Buy a house or vacation home
6. Diversify investments
However, another theory is that Micron insiders are selling relatively small amounts of stock to help keep Micron stock price lower. This is not immediately obvious and is probably not done consciously. The same management that is selling stock in relatively small amounts will benefit from keeping the stock price artificially low for now (see discussion of purchase of convertible bonds above and below).
Result: One reason for Micron insider trading is to help keep stock prices lower (likely subconsciously) to allow less costly purchase of convertible bonds. This in turn will reduce the cost of retiring convertible bonds and increase the long-term price of Micron stock . . . and management options.
Refinance of Convertible Bonds
Above I described the reasons that Micron has convertible debt and that they are committed to reducing this convertible debt. Here I will focus on the impact of price of Micron stock on the cost to retire the existing convertible debt. Convertible bonds allow the bonds to be converted to shares of Micron stock under specified conditions. When retiring the debt, Micron can either provide the converted shares or pay cash to retire the debt. The cash paid not only has to pay for the face value of the bonds plus interest but also must compensate the bond holders for the increase in stock price - typically above a certain negotiated price. There are lots of variables in convertible bonds. The bottom line is that convertible debt can be very expensive to retire when the stock is increasing in price.
Kipp Bedard, the Micron Vice President of Investor Relations noted in an email to me that "with the converts we have outstanding a 2 dollar stock move costs us in the neighborhood of $500m."
With regard to uses of cash "Our first priorities are reducing the dilutive effect of the converts AND reducing the debt to cap ratio back into the 20-25 percent range then begin looking at other programs. Kipp"
By the way, Micron purchased capped calls to offset the cost of repurchasing convertible bonds as the stock price increases. Micron has retired some of the convertible bonds but continues to hold all the capped calls as a significant investment in the future of Micron stock.
Result: Management, where they can, is arranging the financial affairs of Micron to delay the increase in stock price to minimize the cost of retiring convertible bonds. This benefits all stock holders over the long run.
The memory industry is very strong - facing years of rapidly increasing demand for memory to meet the Gold Rush of high tech devices around the world - think memory for the internet of everything. Micron with its existing fabrication facilities around the world, numerous patents and collaboration with the biggest high tech companies is uniquely situated in a consolidated memory industry to meet this rising demand for memory in a customized way that maximizes profits.
By following the money we can see that Micron management is arranging its financial affairs to maximize long term stock price by appropriate accounting, building a strong and consistent financial foundation, developing new memory technology and collaborating with customers to meet their specific memory needs. Management is not focusing on short-term increases in stock which would be detrimental to the cost effective repurchase of convertible bonds. These actions are all beneficial to long term Micron investors.
Watch the capitalization-to-debt ratio. When it gets close to .25, then the stock will jump - most likely in 2015. In the mean time Micron stock price will continue in the channel that it has enjoyed since October 2012 - consistently averaging an increase of approximately $1.20 per month. At this rate Micron will reach $38 by the end of 2014 - not quite $40.
Disclosure: I am long MU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.