- Micron's fundamentals are solid and the stock is oversold.
- The market's fears about the effects of a NAND oversupply are unfounded.
- Micron's future success depends very little on NAND.
"The question is, "what will the market pay for a share of Micron that earns $5?" A P/E of 10 would take it to $50 or more. Eventually. I say eventually because it has been my experience that many analysts and institutional investors are dumbfounded by these big moves and don't catch on for a while. When they do catch on, they could "bubble" it up to $100/share.
So, this is the "Single Best Idea" that I have for the next two years, and "if you could only buy one stock," make it Micron."
- Seeking Alpha, "Micron: If You Can Buy Only 1 Stock, Make It Micron", June 10, 2013, Russ Fischer
"One man alone can be pretty dumb sometimes, but for real bona fide stupidity, there ain't nothin' can beat teamwork."
- Edward Abbey
I have been writing about Micron (NASDAQ:MU) for five years now, ever since Russ Fischer made his famous call. I remember being fascinated by his strategic vision. His analysis of the downstream effects of Micron's acquisition of Elpida was persuasive - his arguments compelling and actionable. You didn't have to be a technology guru to understand it. Boiled down, he presented an opportunity to buy cheap shares ($5 and change) in a company that had just acquired (for pennies on the dollar) the 4th largest memory manufacturer. And not just any memory maker, but a company which had just scored a multi-hundred-million-dollar contract with Apple (AAPL). So short-term it was golden and in the longer term - well the thing we needed to remember was that four minus one equals three - just three large DRAM makers were left.
Hmmm… Where have I seen this plot before? Industry consolidation to a few players from many which leads to new found capacity discipline, which leads to pricing power, and from there to rising revenues and profits. There's a word - what's that word - oh yes - it's called oligopoly. PC-DRAM might be a commodity but still, it's vital and if only three suppliers have oligopolistic control of 93% of the world's supply? Well now - we've got an entirely different ball game, don't we?
And the really delicious thing about it was that the big named industry analysts were missing it. Readers of Seeking Alpha were, thanks to Russ, getting a rare chance to get in early on as close to a sure thing as the market can offer. Play ball! And so it began. And here we are today, and even with the latest series of stupid algo tricks, MU is 10X up from where Micron was back then. Not bad, wouldn't you agree? But it hasn't been one smooth climb, has it? Things haven't turned out exactly as Russ expected. We never did get that "bubble" and it is that issue that I want to talk about now, because it is still affecting the stock.
And when I say "still affecting", I offer as exhibit "A" the sell-off in Micron after their stellar Q2, FY '18 earnings report. Now to be clear this sell-off was caused by a confluence of factors - among them trade-war fears, on-going political turmoil, tech sector sell-offs in the wake of the Facebook (FB) revelations, legislative gridlock, interest rate fears, and possibly some good old fashioned profit taking - but I believe the principle factor was the continuing talk of a NAND glut - by Chris Danley of Citi among others - that was amped up by algo-driven selling which fed on the generally negative sentiment of the week. It didn't help that a first-blush reading of Micron's Q2 earnings call seemed to support Danley's concern. The company reported that QoQ NAND ASP's dropped in the "mid-teens" and followed that up with an announcement of more clean-room space in Singapore in the FY '19, 20 period. The fact that this fab build out would not add to overall NAND wafer capacity and that the large drop in NAND ASP was caused by a one-time factor - a large sale in Q1 of higher-priced MLC, which skewed the Q2 comparison - did not seem to register.
Oh well, another day, another unfathomable market selling spasm. Unfortunately, the sad truth of the matter is that we are still dealing with the long-tailed overhang of memory market conventional wisdom that memory makers will inevitably over build, which in turn leads to the hair-trigger (over) reaction of many investors.
We all know how we got to his ugly number 5-handle on the PE, right? All together now - let's hear it for the "C" words - "commodity". And there's another one - "cyclic". The dominant Micron narrative is that no matter how good today is everything goes to hell tomorrow. Either the industry over produces, or demand falls off unexpectedly, and supply now exceeds demand, thereby producing adverse revenue and profit results for industry participants. All industry participants have been affected by this - Micron possibly most of all. The challenge for the industry as a whole and for Micron in particular is to change this narrative regarding their ability to reliably generate increasing revenues and profit.
Fact is, the narrative already has changed on the supply side. Particularly in DRAM, the three remaining suppliers have all made it clear that they have no interest in overbuilding DRAM capacity. But what about demand? Nothing can have changed there, right? No matter how well the industry's suppliers have managed capacity, there's always the chance that global economic conditions will weaken unexpectedly, thereby creating an oversupply situation in DRAM. But that's no less true of Boeing, Microsoft, or any other global company - they can all be overwhelmed in extremis and they're not dealing with a forward PE below 5.
And NAND is definitely more challenging - with five suppliers now that Micron and Intel have formally split there is a much more complex supply environment and thus many more opportunities for miscalculation in building capacity. I have argued that there is immense latent demand for NAND that is emerging as IoT is built out, data centers migrate to the cloud, and pc builders adopt SSD technology, but I will concede that any number of factors could potentially knock down demand below the 45% capacity increase the industry is building in 2019 or 2020. (Note - I do not expect that to happen.)
So is that "C" narrative intact? As much as I hate to say it, a clear-eyed response to that question must conclude that the answer is: not as much as the market thinks but there remains a legitimate question regarding the industry's ability to manage the NAND demand/supply balance, especially when the industry can produce 40% + production gains in NAND just by virtue of technology node advances. This is a problem that we don't have with DRAM. Node productivity has slowed considerably and there is little evidence that the 20% bit density increases we are seeing with the "1X" generation will get any better with "1Y".
So the problem is NAND demand and the real issue is - does it matter? And the answer, as you might suspect, is a mixed bag. It does matter for the industry overall and it especially matters for Intel (INTC) and Toshiba (OTCPK:TOSYY) and Western Digital (WDC), who make only NAND. (And yes, I am ignoring XP sales for calendar year '18 at any rate.) But does it really matter for Micron? My argument is no. Investors would do well to focus on the story the following chart tells: (data from Micron's Q2 FY '18 10Q)
So right off the top we have $4 out of every $5 of profits coming from DRAM but that number understates the full story. Depending on how big you assume Micron's MCP business is and what average content you assume is sold in the MCP packages - MCP's contain both DRAM and NAND - Micron's Q2, FY '18 profits were 85% to 90% from DRAM. Going forward, you wouldn't go far wrong if you used as a rule of thumb that $9 out of every $10 of Micron's profits come from DRAM.
Ok now, work with me on this. I say Micron, you say DRAM! I say DRAM, you say Micron! Micron - DRAM, DRAM - Micron. Go! Team! But I digress… Where were we? Oh yes, we were talking about NAND, and the question is does it matter to Micron? For FY '18, with the latest forecast for DRAM ASP growth this year at 36%, that answer would be - not a lot. Don't get me wrong, NAND revenue and profit growth this year would be nice, but that's all it would be - a metaphorical cherry on top of a really big chocolate sundae.
So let's put some numbers around this and work three scenarios for full fiscal year revenues and earnings. All three scenarios will assume that Micron DRAM bits grow at 20% and DRAM ASP's grow at 36%. Scenario 1 will further assume that NAND bits grow at 50% (mirroring Micron's statement that they would outgrow the industry and the industry would grow at 45%) and that the quarterly-weighted ASP drops -21%. Scenario 2 assumes the same DRAM data but changes the NAND ASP YoY drop to -30%. Scenario 3, the real nuclear winter scenario, assumes DRAM stays the same and NAND ASP's drop 32% YoY (to just above Micron's cost). Please note that the NAND GM% number is as of Q4, 2018. Please also note that the Q4 over Q4 percentages are forecasted prices as of the end of Q4 compared to the same time last year. The year over year numbers are the average prices of the four quarters.
See the pattern here? A 36% DRAM ASP hike on the year for Micron means that even if the bottom falls out of the NAND market (as in scenario 3), Micron still makes an unprecedented amount of money this FY. Will we get to 36% DRAM ASP? Maybe not, but even if DRAM pricing is flat through the end of the year the company has an excellent chance of earning $11 this year. Not bad for a $50 stock.
So let's follow the scenario road as it winds through fiscal 2019. The first two scenarios will assume DRAM prices stay absolutely flat during 2019. Scenario 3, however, is more pessimistic with DRAM ASP's dropping 21% Q4 over Q4 and 6% on a yearly averaged basis. DRAM bits grow another 20% and NAND bits come down a little to 45% growth. The three NAND scenarios basically paint a picture of a bad NAND business in Scenario 1 to a horrific collapse in Scenario 3. Here's how it lays out:
Let's wrap up. If DRAM prices hold up this year and stay flat next year the Micron NAND business can run at -30% gross margins and the company will still make $10/share in each of the next two years. We could do a similar analysis for the other two DRAM makers - Samsung (OTCPK:SSNLF) and SK Hynix (OTC:HXSCF), and we'd find a similar profit equation. Except for one thing - they both make a lot more DRAM than Micron, so they are even more leveraged by high DRAM prices. Sanjay Mehrotra of Micron has already stated unambiguously that Micron's DRAM build out in 2019 is intended only to maintain their current wafer capacity. Given that signal, and the expense and difficulty of scaling DRAM, what reason is there for either Samsung or SK Hynix to put their enormous DRAM profits at risk?
One last question. Can NAND get as bad as we have painted it in the above scenarios? The answer to that is no unless we assume that IoT and edge computing are a total fail over the next two years. On a tactical level, with 30% + cost decreases this year and next Micron's costs are getting close to the industry's best (at Samsung) and they can weather lower costs much better than at least half the industry's suppliers, including Toshiba, Western Digital, and SK Hynix. On a strategic level, NAND only players Intel, Western, and Toshiba have a compelling incentive to moderate capacity increases if an oversupply situation starts to develop. Finally, and probably most importantly, the price drops in NAND presented in these three scenarios are so large that demand will be stimulated to much higher levels than currently projected. But the real point is that we could spend a lot of time and words discussing this issue of NAND demand and, for Micron at any rate, it really doesn't mean much.
We started this article saying that Micron and the memory industry as a whole need a new narrative to replace the old "commodity" supplier meme. We're not fully there yet for the industry - particularly those companies tied to NAND - but for Micron, we've got a start on it. The new narrative starts with DRAM and we'll add new memories to it in the next article but for now let's keep it simple. I say Micron, you say - yeah - DRAM!
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
This article was written by
Analyst’s Disclosure: I am/we are long MU, WDC, NVDA, PSTG. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.