In my short time investing, one of the most important rules that I have learned is that I should never be afraid to change my opinion when warranted. This rule has saved me time and time again and made sure that I never got too greedy. And because of this rule, I always challenge my own views to ensure that I truly understand them and there is no lapse in judgment.
Back in September, 2010, I had recommended Micron (MU) technology to my readers as an undervalued company and that it was worth significantly more than what the market perceived it to be. It turned out that Micron became my most profitable investment in the past year. I had recommended and bought the stock in the mid $6 range, and sold out close to $11. At the time I was looking at Micron, it was not liked by too many investors. Doing my research in September, all I could find were pessimistic articles on the stock. Fast-forward to December, the stock had jumped 70% and everyone was jumped on the bandwagon raising price targets and recommending the stock as a buy.
As Warren Buffet always says, "be greedy when others are fearful and be fearful when others are greedy." The sudden rise in optimism following a share rally got me a little worried. It was not the fact that I doubted there was growth potential for Micron in futures years, but rather has that growth already been priced in? To see if this was the case, I conducted a discounted cash flow valuation of the stock using my assumptions of growth, an upside case and a downside case.
One of the key drivers of growth for Micron in the next few years will be a rebound in PC demand due to an upgrade cycle to Windows 7 worldwide. Despite the growth in Apple (AAPL) computers and tablets, PCs are dominating the computer world, with majority of the users still running versions as old as Windows XP. Windows 7 is the first reliable operating system by Microsoft (MSFT) since the release of Windows XP over a decade ago. As companies and household begin to upgrade their aging old systems to the new operating systems, DRAM and NAND memory sales will benefit significantly.
Demand for Micron products are indirectly driven by demand for computing products. A key innovation of the newer PCs is multi core processors that require additional DRAM and NAND flash memory, compared to the PCs that were sold a decade ago with single core processors.
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So in my opinion, the semiconductor industry is at the beginning of another cycle of strong growth which should fair well for Micron in the next few years. However, due to the cyclical nature of the industry, I expect sales to fall off following the initial demand surge. In my model, I held the following sales assumption in my base case based on forecasting individual product sales (DRAM, NAND, NOR):
2011 – 11.1%, 2012 – 26.8%, 2013 – 29.7%, 2014 – 17.2%, 2015 – 4.1%, 2016 – -10%, 2017 – -11.8%, 2018 – 5.9%, 2019 – 5%, 2020 – 5%.
COGS, SG&A, R&D and Capex assumptions:
Gross margin for the memory chip industry isn't the most attractive feature. Due to the relatively fixed cost nature of the goods and the volatility in average selling price, Micron's gross margin tends to vary a lot year by year. In my model, I made assumptions that the ASP of chips will increase in the coming two-three years due to the higher demanded cause by a shift to Windows 7 operating PCs. This shift should give Micron relatively stronger gross margins to work with. However, in 2015 onwards, I predict gross margins to shrink to very low levels due to a fall in ASP caused by a fall in demand for chips.
Looking at historical data, SG&A, R&D and Capex, all of them tend to vary between strong demand and weak demand years. In the past, management employed all three depending on market conditions and expectations for demand. Going off this data, I set future assumptions higher for the years prior to where I saw growth (2012, 2013) and lower for years where I saw a fall in demand (2014 – 2016). The semiconductor industry is highly capital intensive, so management has to ensure sufficient Capex spending to meet higher demand. Capex picked up significantly in Q1 and Q2 of the current fiscal year, and I expect it to continue through for the next two years.
Weighted Average Cost of Capital:
For WACC, I used the standard CAPM formula to calculate cost of equity. However, instead of using historical equity risk premium, I calculated the implied equity risk premium (5.69%) using a 6.95% expected growth rate in dividends and buybacks. Using this data and the after tax cost of debt for Micron, I arrived at a WACC of 12.69%
For the actual DCF calculation, I took the 2020 estimated EBITDA, gave it an exit multiple of 4.0x, which is a little higher than the implied EV/EBITDA multiple, discounted the EV to present value, and calculated the equity value out of the EV value to arrive at an implied per share price of 9.15, 19% lower than Micron's per share price as of close on Friday. Using the upside assumption, where I assumed growth will be a little higher than my expectations, I arrived at a per share price of 14.08. And using the downside assumptions, I arrived at a price of 6.79 a share.
From these calculations, it seems as if the stock has priced in majority of the growth expectations. Even with an unlikely higher growth scenario, my DCF implies a price only 24% higher. With that said, I don't think Micron is a buy at this price level. The margin of safety is too small to assume that the company is truly worth 24% higher, and the risk to reward ratio is not in favor of the investor.