A necessary part of valuing an investment is preparing a conservative analysis, because you want to be sure that your investment is equally sound under less than ideal conditions. This has often been referred to as a "margin of safety." What drew me to Micron (NASDAQ:MU) a year ago, and continues to impress me, is its wide margin of safety.
Worst Case Scenarios
When I value Micron I come up with two worst case scenarios:
a) What if the memory industry overexpands and destroys the average selling price of chips?
b) What if demand drops and the memory industry never again needs to increase the number of wafers produced?
The first scenario does not concern me due to Micron's position in a memory oligopoly. It's in the best interest of the few remaining members to keep pricing at artificially elevated levels, as you'll know if you've observed the hard-drive or oil industries. I won't argue the point of oligopolies here - others have covered that quite well.
The second scenario seems ridiculous. The semiconductor industry has continuously expanded since its inception, and 90% of the world's data has been created in the past two years. Moore's Law doesn't keep up with that kind of exponential growth. Still, I'm constructing a "worst case scenario," so let's pretend. What happens if the memory industry never expands again?
In 1965, Intel (NASDAQ:INTC) co-founder Gordon Moore observed that technological advances allow the semiconductor industry to squeeze twice as many transistors into a given area every two years. Remarkably, this has remained true for the past five decades, though we're finally beginning to see this pace slow, as increasingly complex tricks are required (like 3D NAND in the memory storage field.) The consequence of Moore's Law is that every two years we can have twice as many memory chips with a certain number of bits, or the same number of chips with twice as many bits, or something in between these two choices. This allows the memory industry (and other chip industries) to keep expanding their production from a given wafer of silicon. However, over the long term, this has never been enough - the number of wafers has only increased with time, despite Moore's Law. We have an insatiable appetite for chips.
The Steady State Case
Outside of Samsung's (OTC:SSNLF) Xi'an, China fab that is gradually ramping a small amount of 3D NAND production, the number of wafers is holding steady, meaning nearly all of the capacity increase this year comes from an extension of Moore's Law. The increase in capacity is not quite expected to match demand. Kipp Bedard, March 3rd:
"So you got supply coming in that low 20s to mid-20s, you've got a demand situation that's looking 30%, probably maybe a little bit higher than that this year. So demand looks pretty good to us in DRAM, the demand supply relationship."
"Overall supply probably increases 35% to 40% this year, and I think demand is going to be just in that 40% to 45% range probably encouraged little bit by ASP in some of these segments."
Should the market hit any pockets of weaker pricing, Micron is now quite willing to hold inventory because they are bargaining from a position of strength. From the analyst day in February:
"As opposed to what historically has been a business that has been driven by end of quarter deals from our competitors and from customers knowing our fiscal year better than we do the change is we don't feel compelled but we have to drive inventory down just because it's a memory business doesn't matter strategically we may hold inventory for better margin opportunities. So we will continue to drive optimum performance but also not feel the pressure necessarily to react by cutting prices and selling inventory, because we believe we have good homes for this capacity and that is a big shift in how the memory business can operate going forward."
Strong projections for 2014 combined with the willingness to hold inventory mean that every bit of capacity will be used this year, and product will be sold at a favorable price for Micron.
If we imagine that future years will likewise be (just barely) satisfied by current wafer capacity, I would suggest that revenue would reach a steady state, and future earnings could be calculated based on current earnings.
In the quarter reported January 7th Micron earned $.77 per share on just over $4 billion in revenue, with a consensus estimate of just under $.44. The consensus estimate for the quarter to be reported on April 3rd (fiscal 2Q) has recently risen as high as $.74 per share, and my estimate is $1.02 per share, also on just over $4 billion in revenue. Here are two quality analyses of the quarter you may want to review.
Regardless of what number you want to go with for this quarter, it's clear from a glance at Micron's guidance for DRAM and NAND bit production, ASPs, and costs that the April results will top that of January. Micron has repeatedly confirmed its estimates from January. Kipp Bedard, March 3rd:
"But all in all it looks like the market's pretty much like we expected."
A Typical Quarter
The analyst community seems to have the mistaken belief that current pricing is because of the fire in Hynix's Wuxi fab last September. While that certainly gave a temporary boost, it was mostly to spot pricing, not contract. In January Hynix reported that Wuxi was back online, and since then has been bringing spot pricing back to pre-fire levels while contract has remained steady. I explained this phenomenon in my previous article. Kipp Bedard was asked on February 12th about weakness in mobile DRAM contract pricing reported by DRAMeXchange, and he replied [6:45]:
"we have not seen that pressure that they've talked about"
He also made the point that pricing was steady before the Wuxi fire [3:25]:
"I go back pre-Wuxi fire and I look at about two and a half to three months of flat pricing..."
In other words, Hynix's fire in Wuxi may have given a boost to spot prices in the slow part of the year, but prices were steady both before the fire and after the fab resumed production, so pricing has been primarily about the long term supply and demand situation. Long term, demand is expected to continue to be slightly above supply, so revenue should remain at or above current levels. Prices will fall, but costs and bit production will improve thanks to Moore's law.
I expect future quarters to generally be as strong or stronger than the current one. Starting in the quarter to be reported in July, Micron will have a margin sharing agreement with Inotera which I estimate will add an extra 3 cents per share, per quarter. Micron has reduced dilution by 105 million shares through repurchase of convertibles, and I expect continued progress on that front. I think we'll see further cost cutting measures like the 5% of the workforce that was shed at the end of last year - testing costs have already been targeted. Another area for improvement is gross margin, as competitor SanDisk (SNDK) is 13%-15% ahead of Micron, a gulf that could certainly be narrowed through measures like improved offerings in SSDs. Finally, I expect the memory oligopoly to give Micron and the other participants a pricing advantage which should further boost margins for all involved.
Even in the overly-conservative scenario where the memory industry's wafer starts remain stagnant, never growing (or shrinking) again, I would expect Micron to make more than a dollar per share per quarter, putting the forward PE somewhere under 6. As overly-conservative scenarios go, this is very attractive and makes Micron an excellent value investment. If instead the memory industry should grow with time as I expect, there's no telling how well Micron will do.
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.