Why Einhorn Is Right About Micron

| About: Micron Technology (MU)


We think hedge fund manager David Einhorn is right about upside in Micron's shares.

Micron Technology posts a Valuentum Buying Index score of 9, reflecting our "undervalued" DCF assessment of the firm, its attractive relative valuation versus peers, and very bullish technicals.

The firm is one of the highest ranked companies in our expansive coverage universe.

We think hedge fund manager David Einhorn is right about owning Micron's (NASDAQ:MU) shares. Einhorn believes the consolidating industry in which Micron operates will result in a more rational playing field and better performance for all participants, which have had a troubled past due in part to irrational pricing behavior. The Economic Castle rating, which considers a company's future economic-profit spread, is consistent with Einhorn's views about improving industry structure. Let's evaluate the firm's position, arrive at a cash-flow-derived intrinsic value estimate, and run the firm's shares through the Valuentum process.

For those who may not be familiar with our process, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas - as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF - that's why we focus on relative value - and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than our process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Micron Technology posts a Valuentum Buying Index score of 9 on our scale, reflecting our "undervalued" DCF assessment of the firm, its attractive relative valuation versus peers, and very bullish technicals. This is one of the highest ratings in our framework, and we are strongly considering shares for addition to the Best Ideas portfolio - the only hold-back being that we're already quite tech-heavy. But with that said, let's dig into the report.

Micron Technology's Investment Considerations

Investment Highlights

• Micron Technology's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits
ugh the course of the economic cycle. But our new Economic Castle rating indicates that forward economic-profit generation should be expected.

• Micron makes NAND Flash (abt 45% of sales), DRAM (abt 40% of sales) and NOR Flash (abt 15% of sales) memory, as well as other innovative memory technologies for use in computing, consumer, networking, automotive, industrial, embedded and mobile products.

• Micron Technology's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.

• Competition is fierce in the semiconductor memory market and includes Samsung, SanDisk, SK Hynix, Spansion and Toshiba. Such intense rivalries have often resulted in industry overcapacity, pricing pressures and painful cycles. Margins should be watched closely.

• Though competition is fierce, Micron seeks to drive stronger end-to-end high-value product execution, making high-value share its focus. Operational efficiency will be key as it moves up the value chain.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Micron Technology's 3-year historical return on invested capital (without goodwill) is -0.8%, which is below the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation rating of VERY POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

We recently rolled out the Economic Castle rating, which focuses on the cumulative economic profit that it expects a firm will generate in the immediate next five years. Valuentum's Economic Castle rating assumes that "economic profit" (economic value added, EVA, ROIC less WACC) is the primary factor in assessing the value that a company generates for shareholders. Whereas an economic moat assessment evaluates a firm on the basis of the sustainability and durability of its economic value creation stream, Our Economic Castle rating evaluates a firm on the basis of the firm's future cumulative economic profit that it will deliver to shareholders. Firms with the best Economic Castle ratings are poised to generate the most economic value for shareholders, regardless of their competitive positions. We're expecting a five-year average economic profit spread of about 16 percentage points for Micron. Though this is not nearly as good as a firm such as Apple, for example, we're expecting Micron to generate value for shareholders in coming periods. The future is all that matters in investing.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Micron Technology's free cash flow margin has averaged about 3.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Micron Technology, cash flow from operations decreased about 27% from levels registered two years ago, while capital expenditures fell about 51% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Micron Technology's shares are worth between $24-$40 each. Shares were trading just below $24 when we originally published Micron's VBI rating of 9 on our website and are currently exchanging hands just under $27. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $32 per share represents a price-to-earnings (P/E) ratio of about 28.4 times last year's earnings and an implied EV/EBITDA multiple of about 16 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 15.8% during the next five years, a pace that is higher than the firm's three-year historical compound annual growth rate of 2.3%. Our model reflects a five-year projected average operating margin of 22.3%, which is above Micron Technology's trailing three-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Micron Technology, we use a 9.9% weighted average cost of capital to discount future free cash flows.

Our discounted cash-flow process allows us to arrive at an absolute view of the firm's intrinsic value. However, we also understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money-managers - those who drive stock prices - pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash-flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. We compare Micron Technology to peers EMC Corp (EMC), NetApp (NASDAQ:NTAP) and SanDisk (SNDK). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $32 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Micron Technology. We think the firm is attractive below $24 per share (the green line), but quite expensive above $40 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Micron Technology's fair value at this point in time to be about $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Micron Technology's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $44 per share in Year 3 represents our existing fair value per share of $32 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

In the spirit of transparency, we show how the performance of our Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

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.

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