- As many companies disown or halve earnings projections due to COVID, Micron shows its pedigree by raising guidance and reiterating an improving future.
- One factor is company-specific: the remarkable diversification in Micron’s supply chains that enabled production to be reconfigured in the face of country lockdowns and specific bottlenecks.
- The second factor is a new secular tailwind: a rise in Home/Office computing that’s led to a surge in digital memory for the offsite employee. Plus, 5G mega-memory smartphones!
- A perennial investor fear has been inventory obsolescence. The article substantiates why changing industry dynamics necessitate larger inventories and why this is no longer a precursor to a bust.
- An invaluable insight was articulated by the CEO only last week, on why the ’18/’19 volatility in DRAM ASPs is highly unlikely, via a new maturity in data center mindsets.
Micron (NASDAQ:MU) has just shown its excellence: where most companies are busy disowning forecasts or halving them, Micron actually raises for the next quarter and states visibility through COVID is improving. The revision was articulated at the Bernstein Conference by CEO Sanjay Mehrotra only last week. Valuable insights were divulged and are detailed here, but I urge readers to listen to the presentation also.
Before I address insights revealed at the conference, it will be helpful to outline the evolution of the digital memory industry.
The Emergence of an Oligopoly
This section summarises two decades of a dynamic landscape. I have covered the history in more detail in a previous article; please refer to Micron: Fear Of Inventory Impairment Fueled By Trade Spat Is An Opportunity for a deeper analysis.
Two decades (1997-2017) depict an industry rife with innovation and a vicious struggle for survival by numerous suppliers, each vying to secure a place in the future. No doubt, the stellar growth in demand of both NAND and DRAM portended rich harvests for survivors of the digital gunfight. However, the cost to play was a big R&D budget to remain "technologically current" in an industry evolving at a frenetic pace.
Quantum leaps in all aspects of memory design and manufacturing permitted massive cost improvements every year… the rate of technological progress was so rapid that if a supplier couldn't get its inventory out the door in a given quarter, it was virtually worthless in the next, because some other supplier that had kept pace with the digital beat offered a superior product at a lower price. As a result, the pace of innovation rendered inventory obsolete in a matter of weeks if it wasn't sold, leading to a dramatic culling and 'survival of the fittest.'
Natural selection was vicious; few survived. For NAND, since 2001, a dozen suppliers that represented one-third of the market have vanished, leaving just five players that represent 94% of supply (about $40 Bn pa of NAND memory). The consolidation in DRAM has been even more extreme, where three players have emerged to supply 97% of the global DRAM ($60bn pa), displacing a Motley crew who represented about 25% of the market in 2008.
But another law began to emerge in the digital jungle: the law of diminishing productivity. In the early stages of a product lifecycle, the cost improvements were massive, but later, constraints in manufacturing, design, and even the natural laws of material physics led to smaller and less frequent improvements.
The three global DRAM suppliers estimate the current rate of improvement in cost/gigabyte is 5% pa, whereas 40% quantum leaps (both in cost and storage density) were the norm a decade ago. Furthermore, the capital investment necessary for that marginal improvement has soared, as the complexity of squeezing yet another kilobyte of data into a nanometre of wafer that's already three-stories high has deepened.
Well, that tale brings us to today, arguably, the Golden Era of Memory, where a handful of players in both DRAM and NAND are finally in a position to capitalise on the enormous legacy investment, both in intellectual property (patents, know-how) and cutting-edge manufacturing capacity.
A critical issue is the longer life of inventory as we enter the age of a slower rate of marginal improvement. An important issue, still only partially acknowledged by investors, is that the corollary of a slower rate of cost improvements is a longer inventory shelf-life.
The best way to convey this paradigm shift in the industry is via a long-term graph of inventory and profit margins. The data for Micron's graph below can be found in my instablog here.
Note that, in the past, anytime inventory approached around 80 days, Micron would incur a dramatic fall in operating margins, often even going to a loss, as it dumped the worthless obsolete inventory. The inventory dump would be either in that quarter, or one promptly after when the accounting recognized the impairment.
This fear was still prevalent in the last three years, as investors assumed that inventory approaching 100 days would lead to a massive impairment and losses, as it had always done in the past.
Yet this has NOT repeated itself in '18/'19 where the graph above illustrates that margins and earnings remained positive despite inventory days rising as high as 150! Mr Market still has to fully acknowledge the new paradigm in Micron's Valuation Rating (PE).
In the conference, CEO Mehrotra attributed the lift in guidance due to the current demand from Home/Office Computing. The lockdowns have made companies realise a swathe of employees are perfectly capable of working offsite efficiently, permitting a cost reduction in office space. This shift is unlikely to reverse itself after businesses revert to normal after COVID.
So, the COVID environment as we mentioned, has actually resulted in acceleration of the digital economy. And that has seen a surge in workloads related to work from home economy, on the data center side
5G and Mega-memory Phones
A secular driver in memory is 5G networks and the increased need for memory at the consumer interface in applications that involve AI and real-time data processing (e.g. navigation & image-recognition apps).
5G is going to be a long multiyear growth cycle for smartphones. It will reignite the smartphone unit sales. And 5G also drives increased content for memory and storage So, when we look at longer term trends, 5G will be a significant growth driver for multiple years in terms of increased unit sales, as well as increased content for both DRAM and NAND.
Micron 5G implications for Smartphones
Data Centers: The volatility of '18/'19 and the new maturity
Although there was greater discipline in suppliers over '18/'19, demand remained volatile. A key cause was data centers which witnessed a surge from enterprises shifting to the cloud. As demand for data servers roared, many cloud providers - alarmed at the rise in DRAM ASPs - began to pre-order. In 2018, DRAM demand was estimated to rise a frenetic 44% over the previous year, as the pre-ordering exacerbated the tight market. The boom was followed by a fallow period in 2019, as shown in the price volatility of a data server DRAM package below:
Source: Camel DRAM Package
The detail of the DRAM volatility induced by data centers is covered in greater detail in my article Micron Q4 F'19 Earnings: All In Order, Despite Friday's Ghastly Market Reaction - Buy
Cloud Center: Feast to Famine Again?
Those scars still linger in the memory (pun intended) of investors who remain fearful of another bust in the near future. The investor fear and Micron's response is summarized at the recent Bernstein Conference.
What about the volatility caused by data centers? The hyperscalers or the cloud service providers, these companies tend to be very lumpy in their purchases. They tend to have five quarters of huge strengths and five quarters of weakness. We saw 2019 was very, very weak and so far this year extremely strong…. the critical kind of thing that investors are trying to figure out how many more quarters have we got of this data center strength?
CEO Response (my bold italics)
The COVID environment, it certainly does bring lower visibility and does bring some element of uncertainty in all industries. I would like to say that the kind of volatility that was experienced in 2018-2019 kind of timeframe....those cloud customers also would not want to have that kind of volatility, because it is better for them, as well as for us.
Cloud customers definitely have matured in terms of their buying patterns and understanding of the industry as well. And from our dialogue, we were closing with these customers, we are a major supplier to these customers, we worked closely to understand what their demand and product requirements are. And Micron is - they are valued partners to us, the cloud customers, and we are valued partners to them as well.
There is no doubt this is still a possibility, but one must remember even through COVID, data center demand has remained robust. Despite an overall contraction in IT spending in 2020, cloud services is expected to actually post growth, as per Gartner.
Gartner is predicting a 19 percent surge in public cloud services revenues in 2020 as the coronavirus pandemic spurs remote working. Cloud-based telephone and messaging and cloud-based conferencing will see high levels of spending growing 9 percent and 24 percent, respectively.
As an avid investor in Micron, I will be the first to admit the cyclicality is NOT for the faint-hearted. However, in light of the shift to an oligopoly of disciplined suppliers and a more diversified customer base, plus a matured relationship with data centers that will permit a more co-operative, coordinated relationship to mutual profit, all these combine to depict a far less volatile future.
The graph below shows, contrary to previous troughs (sharp decline in ASPs as in 2019), Micron did not move into losses in any trailing 12-month period, but remained profitable (lowest TTM EPS was $2.0 in 12-month to Feb '20, compared to -$0.30 in the previous trough in 12-month to Nov '16).
Once investors fully digest this paradigm shift, Micron's valuation rating (best summarized by the EV/EBIDTA ratio, as per the graph below) is bound to rise. It's still far too early to estimate the next peak in earnings, but I expect the last 12-month EPS peak of $12.1 (Nov '18) to be eclipsed.
I also expect a plateau of EBITDA around $10 per share in a number of years, starting from the fiscal year to May '21. In other words, the feast/famine of the past will be replaced by a sustainable multi-year period of healthy earnings. This is bound to raise Micron's valuation rating. As a first yardstick for valuation purposes, let's stick to EV/EBIDTA ratio of 10X. Using my EBITDA of $10 for F'21, an easy target of $100 is generated. In a word: Buy.
This article was written by
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