- Micron's positive pre-announcement bodes well for the near term.
- Though elevated inventory levels and DRAM spot pricing fluctuations are worth keeping an eye on.
- Micron's earnings profile is evolving into a less cyclical one, with the ongoing re-balancing toward high-value solutions likely to prove accretive.
- With 5G on the horizon, current valuations seem undemanding and present a favorable entry opportunity for medium to longer-term investors.
Those of us who've been around long enough will have less than fond memories of Micron's (NASDAQ:MU) vicious cycles. I do not think this has fundamentally changed but I think the future prospects for memory stocks are a lot more upbeat – yes, the cycles still exist, but the peaks and troughs are set to be a lot more muted going forward, in my view.
To be clear, I think the short-term case for Micron is challenging – the latest spot DRAM pricing data indicates likely weakness in the upcoming quarters. But much of this has been priced in and thinking medium to longer term, I like the stock on demand-side strength as next-generation technologies (5G, AI, etc.) proliferate and the ongoing shift toward higher value-add solutions gain traction.
With both product and end-market diversification on the rise, I think long-term investors stand to win through 1) multiple expansion as earnings predictability improves and 2) earnings growth as the stock benefits from secular tailwinds. At the current ~1.4x fwd book, MU stock may have bottomed, in my view, presenting investors with a highly asymmetric risk/reward opportunity.
Positive Pre-announcement Ahead of the May Quarter
Micron's most recent 8-K filing disclosed a raised forward guidance for the upcoming quarter, on improved demand as well as supply-side dynamics. The raise was broad-based – management now expects revenue, gross margin, and EPS to land above the prior guided ranges. Key drivers include DRAM and NAND demand in response to the recent work-from-home trend, offset by weak smartphone and auto demand. A summary of the latest guide is as follows:
Source: Form 8-K
The Bernstein conference call on the day of the filing provided some useful context into the numbers – there's a fair bit of conservatism going into FY21, with management tightening their belts on opex and capex amid an uncertain macro backdrop. For instance, CEO Sanjay highlighted that FY21 capex is running below pre-COVID expectations, with utilization rates serving as a key lever to manage supply.
So just since you had asked about CapEx, I just wanted to point out that managing supply, another knob, is, of course, underutilization, which we did use in the last fiscal year time frame. On the DRAM side, we had turned down some of the utilization until December of last year." – Bernstein SDC
The capex discipline is a key tenet of the Micron thesis – all indications thus far indicate Micron and its main competitors remain disciplined in capacity additions, which will be crucial amid a weaker consumer demand environment term. DRAM spot prices, for instance, have been steadily dropping over the last few weeks (see DXI chart below), reflecting weakening demand post-COVID but with supply cuts on the horizon, I expect a normalization in the coming quarters.
Somewhat disappointingly for me, there was no firm indication of inventory normalization – as of 2Q20, inventory days remain elevated at 138. Recall that CFO Zinsner had indicated inventory days would remain in the "mid to 130s, and potentially we'll be at that or somewhere around that for this quarter". Expect some moderation in the upcoming quarters, though, as the demand environment normalizes and capex plans are scaled back.
Source: Company Filings
That said, management's reiteration of near-term demand resilience was encouraging, with further sequential revenue growth expected into 4Q. This is partly due to the longer 14-week quarter, but also due to cloud capex strength through the year. Expect a further tailwind from the charge trap NAND transition, which is also ongoing into 3Q20, with revenue opportunities set for 4Q20. Management is targeting a meaningful portion of NAND output to be on charge trap by the end of the calendar year, with a ramp through next year as well. The switch will allow Micron to drive "stronger cost reduction capabilities" and thus, address broader end-markets.
As we have pointed out before, the first-generation of our replacement gate technology has limited deployment across our product portfolio because of its cost competitiveness capabilities. And we intentionally chose the second-generation to be applied broadly. Second-generation of replacement gate is what will provide us a stronger cost reduction capabilities going forward as well." - Bernstein SDC
A Key Beneficiary of the Upcoming 5G Tailwind
With further handset weakness and the potential for a data center pause on the horizon, things do not look rosy in the near term. But for medium to longer-term investors, the setup is encouraging. The supply-side dynamics, for instance, appear favorable as capex cuts through FY21 should drive a more balanced supply/demand.
The upcoming 5G cycle should also benefit Micron, given handsets will have significantly higher DRAM/NAND content. The 5G tailwind has been a long time coming – recall Micron's 2018 analyst day, when management projected the average DRAM content per phone seeing an >75% increase from CY17 to CY21, with the average NAND content per phone also more than tripling, as flagship 5G phones reach 12GB of DRAM and 1TB of NAND.
Fast forward to 2020, and the prediction looks to be coming to fruition, with premium and high-end phones boasting >8GB of DRAM and up to 512GB of NAND. In mid- to lower-end 5G phones, Micron sees >6GB of DRAM and ~128 GB of NAND (from 4GB DRAM and up to 64GB of NAND in 4G phones).
Source: Micron MBU Presentation
Higher memory and storage are a natural consequence of increased video requirements, as well as emerging technologies such as edge AI and AR/VR that are becoming more prevalent in 5G phones. This should significantly extend the demand growth runway - Micron expects ~15% DRAM bit growth and ~30% NAND bit growth in Mobile between 2019 and 2022. Now, if Micron continues to outpace the industry in mobile revenue growth (it posted 104% growth from CY16 to CY19 vs. 28% for the industry), we could see further upside to these estimates as new, memory-intensive use cases emerge going forward.
Source: Micron MBU Presentation
Micron's competitive positioning heading into the 5G cycle is also strong – it has the world's first LP5 DRAM-based uMCPs, which enables longer battery life and high-performance image processing, with ~20% lower power consumption than competitors' offerings.
Source: Micron MBU Presentation
Another key point that bears tend to gloss over is Micron's continued growth and share gains in multichip packages (MCPs) and high-value solutions (up 3x from 2016- 2019). Per management, high-value solutions now account for ~58% of the total mobile market vs. discrete DRAM at ~33%. Further growth in the MCP portfolio (as of 2Q, ~70% of its NAND mix was high-value) should drive a more predictable earnings profile – a key positive for the stock, in my view.
Source: Micron MBU Presentation
Trade Tensions Remain a Key Risk
It is perhaps telling that management opted not to directly address questions related to recent announcements from the US Department of Commerce at the recent events. That said, the company is in a better position today to adjust to any shifts in the demand or supply-side, given the breadth of its MCP and discreet product portfolio.
In a worst-case scenario, any current or future restrictions on Micron's shipments to Huawei could result in a mid- to high-single-digit % impact on total revenue, in my view (assuming no offset). In the meantime, customer inventory in China remains elevated as customers remain cognizant of supply chain risks due to US/China trade tensions, a trend which has been exacerbated by COVID-19.
Undemanding Valuation Relative to the Secular Tailwinds
MU currently trades at ~6x fwd EV/EBITDA, well below its historical trough multiple despite a structurally improving model. At current levels, I would be a buyer, with a target price of ~$80 on a ~2x P/B scenario and a bear case scenario at ~1.4x fwd book, or ~$39, implying a highly asymmetric risk/reward. Key risks to the thesis include DRAM and NAND flash pricing volatility, unforeseen capital investment needs, and supply-side shocks.
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