- Micron is a prototypical GARP stock.
- Second quarter fiscal 2014 results beat expectations.
- Strong free cash flow improvement.
- Implied upside of nearly 60%.
Shares of Micron Technology (NASDAQ:MU) gained after the company reported results for the second quarter of fiscal 2014 in which revenues and EPS bettered the consensus analyst estimates. Revenues of $4.1 billion were 3% ahead of the analyst estimate of $4.0 billion, 2% higher than the preceding quarter and a resounding 98% more than the $2.1 billion in the same quarter of the previous year. Gross margins at $1.4 billion showed an increase of 10% over the $1.3 billion in the preceding quarter and 283% growth over gross margin of $366 million in the previous year period. In a significant improvement, operating income of $869 million rose from $551 million in the preceding quarter and an operating loss of $23 million in the prior year's period. Net income amounted to $731 million ($0.61 per share) compared with $358 million ($0.30 per share) in the first quarter of fiscal 2014 and a net loss of $286 million ($0.28 per share) year-over-year. Adjusted net income was $989 million ($0.85 per share) compared with $881 million ($0.77 per share) in the preceding quarter.
The state of the memory chip market
The company said that there was no "bit growth" in DRAM but 35% "bit growth" in NAND sales (which excludes sales to Intel under a long-term agreement). Prices of DRAM declined by 1% year-over-year, but were more than offset by an 8% decline in costs. The 18% decrease in NAND prices was only partly offset by a 12% decline in costs. For the current quarter, the company expects the percentage bit growth of both categories of chips to be in double-digits while prices are expected to decline by low single-digits.
DRAM supply has stabilized despite the return to production of a Hynix facility which was closed due to a fire. DRAM production in 2014 will be down by single-digits because of users converting from DRAM to NAND and bit supply growth is expected to be in the low to mid 20% range. For NAND, the biggest growth factor is expected to be 3-D NAND chips with growth expected to be over 40% for the year. The market continues to be strong and demand is being driven by several strong catalysts.
The impressive cash flow improvement
Cash flows tend to get overlooked when it comes to valuation of a company's stock, hidden amidst all the fanfare that surrounds revenues and earnings growth. Take the case of Micron which generated approximately $2.9 billion in cash flow from operations for the first six months of its 2014 fiscal year. The corresponding figure for the same six months of the previous year was only $470 million which means that the improvement in operating performance has directly translated into enhanced cash flows. Cash flows for investment in the first half of fiscal 2014 were $451 million resulting in free cash flow of approximately $2.4 billion. If this figure is annualized to $4.8 billion, the free cash flow translates into approximately $4 per share meaning the shares currently trade at less than 6 times free cash flow showing a significant undervaluation of the stock.
The future outlook
DRAM chip prices have come down because of the continuing weakness in the PC market but Micron has focused on making these chips for smartphones and tablets. The company's acquisition of bankrupt Japanese competitor Elpida Memory has brought Apple into the fold as a customer. Memory chips continue to be in the early stages of a transformation because of declining growth of supply and improving mix of demand. As a result, performance for the last six months of 2014 is likely to be even stronger than the first. It is not going to be easy for the company to acquire market share from its rival SanDisk Corp (NASDAQ:SNDK) but continued support from its major NAND customers, Intel and Apple, should work in its favor.
The investment thesis
The impressive revenue and profit growth is much larger than the industry average of approximately 5%. EPS growth was positive for the last two years and these trends are expected to continue for the rest of 2014. The company's return on equity, at nearly 32%, is also superior to its industry in addition to the S&P 500. The management of the Elpida acquisition has been sound and benefits are being realized earlier than expected. The current trading price implies a PEG ratio of 0.73 (anything below 1 is regarded as undervalued) and a forward P/E ratio of just over 7 times earnings. Moreover, the current price is only around 6 times the free cash flow for 2014 which again implies significant undervaluation.
The bottom line
The classical definition of growth at a reasonable price is the combination of low price and excellent growth prospects and Micron meets this definition. Against the current price of $22.17, and assuming a 9 times free cash flow multiple for fiscal 2014, I believe that the price could be worth $36 representing upside of almost 60%.