Micron: I'm Calling The Bottom

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About: Micron Technology, Inc. (MU), Includes: AVGO, HXSCF, SSNLF
by: Joe Albano
Summary

Not of the stock but the industry.

Inventory and revenue have turned the corner.

FQ4 has shown the promise of better than guided results as two factors since earnings have provided additional bullishness and the forming of a bottom.

The first reaction to a title like this is: "You can't time the market." And you would be correct. It's a losing battle to time the market at the bottom and the top. As is evident by Micron's (MU) massive move off its recent lows of nearly $32, which I did call as a near-term target in one of my blog posts from May 7 (you get those alerts only if you follow me), I'm not calling a bottom in the stock price.

Chart Data by YCharts

What I am saying is this is the bottom quarter for semis like Micron and Broadcom (AVGO). Why do I specify? Because semis like Intel (INTC) and Qualcomm (QCOM) are facing other internal or customer-related pressures and issues. Micron right now is seeing pressures relieved and other developments cut its way for a change - which I'll cover shortly.

In my article just before earnings, I said I was taking a caution lap going into the call. Several factors, such as the Huawei ban and the China-US trade conflict continuing, were my reasons for hesitation offset by the encouraging trend of negative DRAM pricing slowing. On the call and since then there have been several positive and bullish factors which have given me reason to put the green flag back out - with the factors since being the most encouraging to the bull thesis.

Inventory And Revenue Trends

My subscribers were filled in on last quarter's inventory and revenue trends as well as you in a later public article where I outlined capex and inventory management being bullish. Therefore, I continue to follow the trend I laid out in both of those articles.

First, days of inventory outstanding has begun to turn the corner. That may seem contrary as days outstanding has gone from 134 to 151 (end-of-quarter number) from FQ2 to FQ3. But, that's a slowdown from FQ1's 107 days outstanding. If you recall I used a chart outlining how a top in days of inventory outstanding turns when revenue begins to bottom. Here's that chart updated for this most recent quarter:

Chart Data by YCharts

As you can see days of inventory outstanding looks likes it has shot up again, but it has begun to make the turn. More noticeably, revenue already has started to make the rounding of the bottom.

Not convinced? That doesn't surprise me since both of those numbers seem to still be on a bearish trajectory.

However, with FQ4 guidance provided, we can see the bottom is in this quarter as guidance for revenue is for $4.5B at the midpoint. That compares to the $4.78B the company just earned last quarter, and that's a marked slowdown from FQ2's $5.8B and quarter-over-quarter decline to FQ3 of 26%. Instead, FQ3 and FQ4 are expecting a growth decline of just 5.8%. The business is beginning to see a slowdown in negative growth - this is good.

Moreover, management said it expects to hold inventory around this level and even to look for it to come down. During the Q&A session on the earnings call, CFO David Zinsner had this important tidbit to share:

...and of course we had customers working down their inventories and so inventory was building up in our balance sheet. We do expect now that we're in a place, Sanjay mentioned that we're seeing inventories get to be in a good place in the cloud space, in the graphic space, in the PC space. And so, we would expect to start to see inventories start to come down now.

With customer inventories moderating back to normal levels, Micron is seeing bit demand shipments pick up which means they can begin shipping from its inventory or at least ship directly from its manufacturing lines and not have to build inventory further.

Too Much Focus On EPS

There's been a lot of focus on earnings per share from other contributors, and this is misleading at this juncture in the cycle. With the strategy to manage inventory, free cash flow, and bit supply, there's an operating margin hit occurring, which otherwise would match the revenue trend. Take, for example, the prior quarter's revenue of $4.78B and $1.05 EPS and compare it to the current quarter's expected $4.5B but only $0.45 in EPS.

The "why" of this matters and it pertains to the strategy to get through this down cycle: Cutting wafer starts and building inventory.

The company doubled its wafer start cut from 5% to 10% with regard to NAND while keeping the 5% cut on DRAM so this accounts for the smaller margin. The strategy to maintain positive free cash flow and keep inventory steady requires some sacrifice to operating margins. To limit supply into the market and not to get inventory beyond the limits, it has needed fabs to be at less than full production. There's a lot of fixed costs in the production process, so these wafer cuts directly impact margins.

Additionally, keep in mind management is building NAND inventory at the same time this downturn happened. Replacement gate in NAND was expected at this point, and inventory build was needed as the company expects less bit growth in NAND versus the next generation.

The management team at Micron during this trough is doing a more skilled job at managing its balance sheet and industry output than any of the company's management teams of the recent past, and this strategy is going to look funky on a linear basis as well as a comparison basis to prior cycles.

What's Changed Since Earnings

Here's where things have gotten interesting and increasingly bullish. Since the conference call, a lot has transpired.

The first is the Huawei ban, where hardware companies have been allowed to resume shipments. This occurred not long after the earnings report - in fact, only four days later at the G20 Summit. President Trump didn't lift the entire ban, but the current read is "hardware components from companies such as Intel and Micron can know that they can continue to sell to Huawei."

Considering Micron took a $40M write-down on inventory related to Huawei as "finished goods inventory with Huawei (did) not look like (it was) going to get sold" is suddenly back on the table. This is no small impact as guidance factored in very limited shipments to Huawei for FQ4:

...our revenue expectation in fiscal Q4 is less than what it would have been without Huawei being on the entity list...Of course, our revenue expectation with Huawei is baked into the guidance - Sanjay Mehrotra, CEO

That all changed four days after the above answer to an analyst question. You can potentially factor in up to $200M in revenue if Micron does indeed have the green light to ship all of its typical product to Huawei as "FQ3 ... had an impact because (Micron) could not ship ... any product to them of nearly $200 million."

Suddenly revenue is now in the $4.7B area - within striking distance of the $4.78B from the already-ended quarter. Granted, we could claim FQ3 could have been $4.98B if Huawei wasn't a factor and FQ4 would then still be $4.7B. This is true, but the market priced in the ban, so a reset was needed with FQ4 being granted its Huawei revenue.

At this point, don't forget Broadcom also is feeling the relief here as well since 25% of its guidance cut was due to the Huawei ban. This is an upside benefit for both companies.

But there's a second factor at play, too!

And just by saying there's a second positive factor at play, it seems things have shifted fundamentally for Micron all within a few weeks. Any long-time shareholders know Micron doesn't receive good news at suitable times, or good news is quickly forgotten. But there appears to be a shift in sentiment - meaningfully.

This second factor is a dispute between Japan and South Korea. There has been an extensive comment discussion on a recent Micron article from TickerSquare on this exact topic - commenter Randall A. Dass succinctly putting the problem in view. The long and short of the situation is while Japan is not placing an export ban on materials necessary for semiconductor production, it's requiring licensing to ship these critical materials to South Korea, creating delays of up to 90 days.

Because of the nature of these materials, they can't be stored for long periods, which forgoes the ability to stockpile it, and sourcing a new supplier most likely requires changes to the calibration of the semiconductor equipment. These changes directly impact yields, and anyone who knows anything about semiconductors knows yields are everything.

As all of us know, Samsung (OTC:SSNLF) and SK Hynix (OTC:HXSCF) are the two memory producers on the Asian peninsula - the only major ones besides Micron. This directly impacts the global semiconductor supply.

And, because of this new tension between the main supplier country and the main producer country, the supply of DRAM quickly comes into view. And it gets reflected in average selling spot prices of DRAM.

(Source: dramexchange.com - July 10th session)

(Source: dramexchange.com - July 11th session)

As you can see, spot pricing for DRAM has turned upward in a hurry in back-to-back sessions. This is the market at work in real time, pricing in real issues like the Japan-Korean dispute. This is a quick turnaround from pricing that has seen constant erosion for nearly three quarters.

The above chart is the DXI or DRAM eXchange Index and tracks DRAM chip spot pricing. As you can see, since the beginning of the year the DXI has not had an upturn like this - gaining 4.5% in just two days.

Furthermore, Trendforce (parent company of DRAMeXchange) a month ago predicted a 12.5% decline for CQ3, and now, early in the quarter, it's up 0.25%. Said another way, the quarter was on a 3.1% decline before July 10th.

But, wait, there's more!

Cloud, enterprise, and OEM firms are now sitting much closer to normalized inventories. Normalized inventories are for normal times. Because of the conflict between Japan and South Korea, it could mean abnormal times are ahead. It was only last year when hyperscalers were double ordering to secure memory for datacenters as demand outstripped supply. If supply hits a sudden snag on the Korean peninsula, or only an expectation supply will hit a snag, OEMs and other large customers will begin ordering higher quantities to secure supplies for the seasonally higher demand of the next few months. Bottoming ASPs would then combine with rising bit shipments to create all that is needed to form a memory recovery. Producers can immediately ship from inventories and further quicken the recovery.

What we see with DRAM spot pricing and the DXI is the beginnings of this expectation and buyers of both DRAM and NAND will want to get ahead of this before pricing takes off further.

Technical Chart Analysis

Fundamentals aside for a minute, I've found my followers also enjoy the technical chart analysis. It's what I used to predict the drop from $42 to $32 in my blog. So here's a little rundown of what I see and a peek at what I tell my subscribers of Tech Cache.

What I'm seeing is a lot of recovery in many indicators and a reversal back to bullish momentum. What I'll explain here is my analysis of the short-term movement of the stock, not the medium-term timeframe I used when I discovered the ascending wedge pattern for the breakout to the $32 level.

Right now the stock has hit resistance at $44. A break past this would send it to a gap it created last September at $48.45 through $49.07. But the RSI has become overbought while a near-term gap-up will likely be contended with between $41 and $42. I don't expect the stock to break past $44 at this time but rather reset on an RSI and MACD basis which will likely mean filling the $41-$42 gap and testing the 200-day moving average, as it had broken past both the 50DMA and 200DMA without blinking. A test of these averages should happen in the near term, with the 200DMA being first and the 50DMA potentially being after a bullish crossover of the two averages. Volume has been well above average on this breakout, and this is indeed a good sign of buyers stepping in.

Welcome To The Bottom

With expectations for "strong sequential (DRAM bit shipment) growth for the FQ4 (in cloud)" ahead of the latest events to transpire, the weeks following earnings have only strengthened the fundamental shift in the semiconductor memory industry. Inventory and revenue have turned the corner, creating the bottom and the share price has moved up in anticipation of this.

Now, this doesn't mean chase the stock, as it has risen dramatically over the last few weeks. At $43, the stock has returned to levels which price in less dire expectations. A few things can continue to move it higher, including a resolution to the China-US trade war as well as a breakdown in Japan-South Korea talks. But, there are a few things which may bring it back down such as a quick resolution to the Japan-South Korean dispute as well as a stock chart reset.

With technical chart analysis showing us the stock will likely take a breather, I like acquiring shares on any dips at this point - doing so at a sustainable clip for your portfolio to balance out the volatility (as noted by the massive widening of the Bollinger Bands).

The bottom is here in terms of memory industry fundamentals. EPS does not reflect this because of the strategy to manage cash flows and bit growth, but revenue and inventory are telling the story as they have in the past. I'm looking at Micron for a long-term hold around these levels.

Disclosure: I am/we are long MU, AVGO, INTC. 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.