SK Hynix's Earnings Contradict UBS On Micron

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About: SK Hynix, Inc. (HXSCL), MU, Includes: INTC
by: Zynath Investment
Summary

UBS recently initiated coverage on Micron with a $35 price target and a negative outlook on the entire memory industry.

On April 23, 2018, SK Hynix reported Q1 results with guidance and market outlook that directly contradicts UBS's assertions.

According to SK Hynix's management and OEM memory buyers the memory market should remain strong for the foreseeable future.

(Picture of a wafer from istockphoto.com)

This is going to be a quick follow up on my April 6th article, The Truth About The UBS Micron Report. In that article I went through UBS's coverage of Micron and questioned their claim of potential memory oversupply by the second half of 2018 and into 2019. Please read the article for background.

To summarize UBS's claims, basically they suggest that the total wafer output for the DRAM industry will increase by 170,000 wafers starts per month (wsm) between 2018 and 2019. This represents roughly 15% of the total industry capacity and according to UBS will result in approximately 5% oversupply in the overall industry sometime in 2019.

To backup these claims UBS cites a graph labeled "Company reports, UBS estimates," which is not strictly speaking evidence, and attach the following explanatory paragraph:

Samsung is ramping Pyeongtaek, largely – the company indicates – to offset bit growth loss from migrating to 1x and losses from Line 11 being converted to image sensor production. UBS Asia team is modeling Pyeongtaek ramping to 90k wsm by CYE19. There are indications that MU will be adding clean room space in Singapore to maintain wafer capacity and meet market demand as it works through technology migration. Hynix is also building a 2nd fab at Wuxi (we estimate ~100k wsm) that will effectively double Wuxi capacity once completed. UBS Asia team is modelling an incremental ~40k wsm at Wuxi by CYE19.

From my understanding, and according to Micron's (MU) management, the Singapore clean room expansion is for NAND production, so it's not clear why that's included in the explanation of the projected DRAM wafers starts increase, and the rest of the numbers cited do not appear to add up to 170k wsm. Yes, in the 50+ page report that's the only paragraph that talks about the numbers behind the 170k wsm increase.

That said, this is old news by now. Let's now look at the SK Hynix's Q1 transcript, which was kindly posted by Seeking Alpha in translated form here. SK Hynix (OTC:HXSCL) is a Korean company, and is one of Micron's 2 major competitors, with the other one being Samsung. Rather than looking at SK Hynix's specific results, we will concentrate on their outlook for the overall memory market and see how it jives with that of UBS.

Peter Li from Citigroup Global Markets Securities asked the following question, no doubt inspired by UBS's report, due to its conspicuous phrasing:

[R]ecently there is increase in DRAM capacity across the industry that are causing some concerns of possible oversupply in the second half of this year or next year, so what would be SK Hynix's view regarding this?

And here is the answer provided by SK Hynix:

Now, I would like to take your [...] question about the capacity increase across the market and the concerns for oversupply. Now, starting from last year there has been limited bit growth in DRAM supply because of the continuing tech migration. And as a result although the demand has grown considerably because of the limited bit growth coming from the tech migration, that demand growth has not been fully met. And again when we look at the demand, so customers demand then we can see that of course for the smartphone's although growth is limited, but we are still seeing some growth and then very rapid growth in other applications. So given such demand growth that we see these days, it's simply not enough to fulfill such demand growth using only tech migration. So this means to meet the demand growth then it is almost unavoidable that we increase capacity by increasing investment. So consequently we believe that for the suppliers they will have to meet the demand growth by increasing wafer capacity by 6% to 7% per annum. Then now from the market there are some concerns about the supply as the capacity continues to increase with growing investment. But then as I mentioned earlier because the bit growth is blowing down from the tech migration, for the suppliers I believe that they will be able to make some adjustments based on their investments or capacity increase. So I believe that - thanks to this demand and supply dynamics in the market will remain favorable.

The emphasis above is mine. Let's unpack that. Basically, what SK Hynix is saying is that there is high demand and rapid growth of that demand for DRAM from various applications. In other parts of the transcript they indicate that the fastest growing demand is in the cloud and server market from both American and Chinese tech giants.

This is not at all surprising. AI powered by deep learning is the future and it requires a lot of DRAM. Incredibly large datasets and neural networks need to be loaded into DRAM to provide quick access to said models and data in order to keep up with the processing power of modern GPU accelerated supercomputers. Most tech companies are banking heavily on AI, and AI needs DRAM and super fast and low latency storage that is provided by NAND at the moment and likely by 3D X-Point in the near future.

As an aside, Intel's (INTC) Optane drives have industry leading latency, a feature quite important in machine learning, and one that hasn't been properly highlighted yet. I think both Intel and Micron will do quite well in the near future with 3D X-Point, once this technologies' power in AI applications has been fully realized.

Ok, so the world needs DRAM and the need for it is growing by leaps and bounds, we have covered that. What else does SK Hynix say? They point out that this extra demand can't be fulfilled using only tech migration, which is a fancy way of saying shrinking to a smaller production process and increasing layer count. Just to keep up with demand, 6% to 7% per year growth in supply is necessary, even at current levels.

Let's look at another question, this time from Korea Investments and Securities:

We see that the price increase continues for server DRAM and it was mentioned recently that there is no resistance coming from the buyers despite the price increase. [H]ow long do you believe that this is going to continue?

And here is SK Hynix's response:

Now, for server DRAM pricing, actually now for the second quarter we have already completed the price negotiation with the major server DRAM customers and basically as the shortage continues, the tight supply continued the customers were focusing on securing the needed volume. Then unlike a smartphone which are ordinary consumables in your consumer products, the servers now, they are more production, so used for production. So in terms of the PCO for data centers then in terms of the server machine portion as well as the server machine components portion, we believe that the investment into them will continue for some time. [...] And then regarding the DRAM pricing, now into the second half of this year, although it is going to ease a bit, we believe that the tight supply will continue. This is also the view that is shared by the customers and that is why they are focusing on securing the volume for the second half of this year.

Again, emphasis is mine. There are two important points in this answer. First, SK Hynix believes that investment in servers and cloud infrastructure will continue strong into the future, backing up what we have talked about above about the need for more server capacity for AI and cloud applications. The more important part of the answer, however, is the fact that their customers are eager to secure supply for DRAM. So it's not just SK Hynix that predicts tight DRAM market for the foreseeable future, but their customers as well. Given that both the sellers AND the buyers in the market are convinced that the supply will remain tight, I don't see where the oversupply projection from UBS is coming from.

The rest of the questions primarily deal with SK Hynix's business, which appears to be doing quite well while being a clear third in the 3 horse memory company race. Since Micron's next earnings are still more than 2 months away, looking at their close competitor's comments about the memory market is quite a good indication of how Micron will be doing in the near future. And that future appears to be quite bright.

Investor Takeaway

Micron continues to be beaten down by negative market sentiment and negative stories from all sides. However, we still believe that they are an exceptional company in a very strong industry, and have a lot to offer a patient investor. We still believe that Micron's fair value is north of $70 per share, but would caution about opening up a position right here. The market appears to be acting quite irrationally when it comes to Micron, and this may continue until the company comes out with a statement and defends its stock and shareholders.

Disclosure: I am/we are long MU. 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.

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.