Why I Think Micron Could Be 45% Undervalued

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 |  About: Micron Technology Inc. (MU)
by: Bottom Up Investing

Summary

Industry consolidation has lead to improved profitability.

Micron could be trading at a 45% discount to its intrinsic value.

The technicals suggests a near term bear market.

Micron Technology, Inc. (NASDAQ:MU), the memory manufacturer, reported solid first quarter earnings that were highlighted by improved profitability margins. This was the first quarter that the combined Micron and Elpida reported earnings, which demonstrated the scale economies of the combined companies.

Looking forward, I see improved profitability and a strong product pipeline. But the ramping of 3D NAND will require substantial capital investments. As the firm transitions into the second generation of 3D NAND, the capital requirements decline, which should improve profitability. On the DRAM side, the capital intensity of the business is declining, which should also improve profitability.

Consequently, if management is able to execute and the product offerings remain competitive, MU could be currently trading at a 45% discount to its intrinsic value.

Recent Developments

  1. Darren Thomas was named vice president of Micron's Storage business unit, which features the company's solid-state storage business.
  2. The company announced the pricing of $600M of 5.875% senior notes due 2022.
  3. The earthquake in Japan could adversely impact MU's DRAM output by a low-single digit percentage over the next 90 days.
  4. MU is rolling out the M550 SSD, which offers faster performance, and longer batter life.

Business Summary

Micron Technology, Inc. is one of the world's leading providers of advanced semiconductor solutions. The company manufactures and markets DRAM, NAND Flash and NOR Flash memory, as well as other innovative memory technologies, packaging solutions, and semiconductor systems for use in leading-edge computing, consumer, networking, automotive, industrial, embedded and mobile products.

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The memory industry's ROIC has been on average negative over the past 13 years. This is well below the ROIC for the semiconductor industry. While some in the industry are optimistic that the high ROIC during 2013 signals is change of fortune for the memory companies, me, I'm skeptical. Simply stated, "Show me the money!"

For the year ending (in millions except per share data):

2011-08

2012-08

2013-08

2014-08E

2015-08E

Net sales

$8,788

$8,234

$9,073

$19,500

$20,865

Gross profit

$1,758

$968

$1,847

$6,045

$6,885

Operating income

$761

($612)

$236

$2,900

$4,173

Adjusted net income

$167

($1,032)

($294)

$2,570

$3,338

Adjusted diluted EPS

$0.17

($1.04)

($0.28)

$2.13

--

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The Elpida Memory, Inc. acquisition improved the profitability margins of Micron; it was also accretive to net sales and net income. It appears MU will be able to generate operating profits more frequently than in years past. Consequently, valuation multiples should expand, or should have expanded, to account for the improved profitability profile. MU is forecasted to earn an adjusted $2.13 per diluted share during fiscal 2014, and net sales are forecasted to increase 7% in fiscal 2015. Fiscal 2015 consolidated operating results reflect management's efforts to improve the gross margin.

2011-08

2012-08

2013-08

2014-08E

2015-08E

Ending financial leverage

1.74

1.86

2.09

2.16

2

Debt-to-capital

0.19

0.30

0.40

0.35

0.30

Cash ratio

0.87

1.14

0.75

--

--

Current ratio

2.35

2.57

2.16

--

--

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The solvency position appears solid and liquidity appears ample. As per management's guidance, the debt-to-capital ratio is forecasted to decline. The firm is expected to keep at least $2B of cash on the balance sheet.

For the year ending (in millions):

2011-08

2012-08

2013-08

2014-08E

2015-08E

Cash flow from operations

$2,484

$2,114

$1,811

$6,435

$6,885

Capex

$2,550

$1,699

$1,244

$2,900

$3,000

FCFF

$14

$589

$795

$3,885

$4,185

FCFE

($591)

$1,277

$945

$3,035

$3,385

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The overall cash flows profile of the firm improved significantly. But free cash flow should be adversely impacted in the current and next fiscal year by the ramping of 3D NAND. The timing of product launches is shown in the chart below, and below that is a chart of the capex requirements. The second generation of 3D NAND will require less capital investment. Looking beyond fiscal 2015, free cash flow should be on a ramp, as the business becomes less capital intensive.

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Looking forward, MU's management has taken steps in the right direction. The Elpida acquisition improved the profitability of the firm. They are trying to have an impact in mobile. There is the push into 3D NAND and there is LPDDR4. Also, there appears to be a relatively clear path to reducing the debt footprint and decreasing the diluted share count. The fundamentals appear bullish.

Portfolio & Valuation

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MU is in a bull market of intermediate and primary degree. But the latent signs of weakness suggest shareholders may be in for a bear market of at least intermediate degree. In other words, the technicals dictate a neutral position.

Monthly expected return

Quarterly expected return

Monthly standard deviation of returns

3%

9.16%

14.22%

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Estimated intrinsic value

Forward price multiples based on base case value

Optimistic

$46.98

P/E: 17.83

Base case

$34.62

P/S: 2.14

Pessimistic

$22.26

P/BV: 4.51

P/CF: 6.48

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The estimated intrinsic value is based on the fundamentals of the firm. The model incorporates the long-term profitability of the firm as well as the risk of that profitability. Based on the base case intrinsic value, MU is 45% undervalued. The risk to the valuation is that MU is unable to sustain consistent profitability.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.