Whether in introductory Microeconomics or studying for a CFA, one of the first concepts taught is that when a product's selling price falls below average variable cost, it's time to shut production. As happens periodically in the DRAM industry, the cash cost of manufacturing DRAM is now moving above its selling price, resulting in production cuts. Something's gotta give and we expect that will be rising DRAM prices in the next few months. With a healthy NAND pricing environment and meaningful synergy from the upcoming Elpida acquisition, it's time to buy Micron (MU) and ChipMOS (IMOS) for whom Micron is its 2nd largest customer.
The DRAM industry is notable for its cyclicality. Numerous DRAM producers have gone bankrupt over the last few decades, and the DRAM price declines experienced in 2011 drove Elpida into bankruptcy. Despite the significant slowdown in DRAM capacity additions in 2012, the rapid deterioration of the PC market has caused DRAM demand to grow even more slowly than tepid DRAM bit supply. We are not optimistic about a recovery in PC demand. We don't think Windows 8 will drive a major PC upgrade cycle and believe Microsoft (MSFT) faces serious challenges. Still, we expect PCs to see some stabilization (or decline at a less brisk pace) which should help DRAM demand somewhat.
More importantly, we think DRAM supply growth will fall further (Powerchip, for example, is exiting the business). At some point, inventory will get cleaned up, and prices will rise - perhaps sharply. Historically, the time to buy Micron or its peers has been when industry fundamentals look terrible. The worse things get, the more pronounced the production cuts will be and the lower the industry capital expenditures for the following year.
With Micron having a solid balance sheet, they will be able to ride out the storm. In the interim, as they continue to shift to smaller geometries, their manufacturing costs will decline over the near term. To quote Micron CEO Mark Durcan:
"In DRAM, 30-nanometer yields are on track, and we should see a nice jump in production and cost improvements over the next few quarters."
Accelerating Manufacturing Cost Declines
While we expect DRAM pricing to stabilize and possibly rise over the next 6 months, and costs to decline, we also anticipate significant profitability improvement in NAND. Since the August quarter concluded, NAND prices have increased over 20%. Sandisk (SNDK) recently reported strong 3Q results and a healthy outlook, a view echoed by Samsung.
Importantly NAND now accounts for 35% of Micron sales.
Source: Micron Investor Data Sheet FQ4-12
Any increase in NAND pricing should fall through 100% to Micron gross profits. We are optimistic that NAND pricing in 2013 will be unusually benign given Sandisk's comments regarding slow industry bit growth (~30% y/y), the accelerating adoption of SSDs, and potentially pent up demand from Apple (AAPL) who we believe is buying less NAND in 4Q than usual, due to iPhone 5 manufacturing bottlenecks, which could lead to greater than typical procurement in 1Q.
Elpida acquisition should be extremely accretive
Finally, the news of October 31st, that Tokyo court has approved Micron's acquisition of Elpida should be a major catalyst to improved profitability in 2013. Given the debtors objections to Micron's bid, we have little doubt that Micron has been extremely restrained in their excitement about the acquisition. After all, if Micron hyped up the multiple hundreds of millions of dollars in synergy/savings they will probably be able to implement in 12-18 month, Elpida creditors would be crying foul.
We think Micron will be able to take out tremendous costs - and likely enjoy several hundred million dollars in cost savings. In addition, we think Elpida's r&d, expertise in mobile DRAM and customer base (importantly Apple), will all benefit Micron. Given Apple's increasingly adversarial relationship with Samsung, Micron stands to be a major beneficiary of additional NAND and DRAM opportunities with Apple - and certainly Apple's historic comfort with Elpida won't hurt.
Valuation, investment thoughts on Micron, and another stock to buy
When DRAM production costs are below selling prices, it's time to buy Micron. Micron shares are about 10% above their 52-week low, and trade at just 0.76x book value. The street is looking for an EPS loss of $0.26 for FY13 (August), with the highest estimate of $0.73. For FY14 consensus EPS is $0.62 with a high of $1.69. We believe the high-end of the range is likely to prove accurate, but we think upside to shares is likely limited to $8 or $9, perhaps $10, if there is a PC resurgence, which would surprise us.
We strongly disagree with fellow author Cris Frangold who thinks Micron could be a $15, if not a $20 stock. There are simply too many investors with too much experience with Micron. Micron is a stock that sees its P/E compress on peak EPS. Savvy institutional investors are aware that just as capacity comes out when memory pricing is too low, capacity is added too rapidly when pricing is high, presaging a deterioration in corporate profits. As much as we like Micron as a trade, barring a currently unforeseen emergent demand driver, we don't see any catalyst for secular DRAM industry growth, or sustainably higher multiples.
Our favorite current stock pick, ChipMOS , which current sports an incredible 35% free cash flow yield, stands to significantly benefit from improving DRAM conditions at Micron and the Elpida acquisition. We've written on ChipMOS multiple times due to its compelling valuation and leverage to high-growth smartphone and tablet markets.
Micron is ChipMOS' 2nd largest customer. Despite the fact that Micron's DRAM revenue declined y/y in the first half of 2012, they outsourced significantly more to ChipMOS than they did in 1H2011.
Micron increasing outsourcing to ChipMOS
Source: ChipMOS 6-K September 28, 2012, Page F-22
ChipMOS noted that 4Q revenues are expected to be flat-to-down 5% due to weakness in commodity DRAM, offset by strength in LCD driver-ICs. We'd expect DRAM to come back, potentially strongly, as pricing stabilizes or improves in 1Q or 2Q, bolstering ChipMOS' 2013 growth prospects.
Equally important, about 5 years ago when Micron selected ChipMOS as its assembly and test partner Micron did not select Powertech or Walton - Elpida's Taiwan-based assembly and test partners. Given Micron is increasing outsourcing to ChipMOS, clearly they are a well-liked partner. In our opinion, the acquisition of Elpida could lead to market share shifts, including significant incremental business to ChipMOS in Taiwan, as well as its underutilized China facility.
Trading at under 3x free cash flow, with no net debt by year 2012, we think a recovery in DRAM is one of many reasons to own shares of ChipMOS, and see dramatic upside to shares (for example at a still huge 16% free cash flow yield shares would be worth $25).
Additional disclosure: We conduct thorough research on our ideas, but our views are our own. Please do your own research.