The Bottom Line
- Micron, being one of three companies in the world dominating the memory / storage industry is an attractive value and a potential long-term compounder.
- Micron’s intrinsic value compounding rate has been 60% over the past 7 years. (ROIC * Reinvestment Rate).
- Current industry headwinds of low memory and storage prices are nearing a cyclical trough.
- Attractive P/E of around 5 gives us a margin of safety.
- Five year average return on equity of around 33% shows consistency.
- Demand for memory and storage only increasing as technology undergoes rapid change and Micron holds a dominant position in the industry along with SK Hynix and Samsung.
- Micron is a rare high quality stock at a bargain price.
- Current Price: $42.90
Micron’s valuation remains compelling despite its recent rally off the lows. It’s a value stock with attractive growth prospects. We think the long-term prospects for Micron and its industry remain attractive, making the current price a bargain. The memory and storage markets, specifically for DRAM and NAND are at or nearing a cyclical low. The negative news and expectations of lower near-term earnings has been baked into the current stock price.
Micron’s ability to cut costs, CAPEX, and manage inventory allowed it to remain profitable and weather the storm. Stock buybacks at attractive levels returned cash to shareholders. When the inevitable upswing in memory chip prices occurs, shareholders will be rewarded. The demand for new storage and memory technologies continues to grow with new developments in cell phone technology, tablets, cloud computing servers, artificial intelligence, and automotive.
Current trade tensions with China and sanctions on Huawei have so far had a miniscule impact on Micron. Any positive developments of a trade deal with China and de-blacklisting of Huawei will be a further boost to the stock price. Recently installed CEO Sanjay Mehrota has been a fantastic capital allocator during the downturn and brings 30 years of experience in the semiconductor industry to Micron.
As a shareholder, you’re in good company with superinvestor Mohnish Pabrai, who recently purchased $70 million worth of stock representing 26% of his US portfolio. Mr. Pabrai usually buys stocks that he believes have multi-bagger winner potential.
An investment in Micron hinges on whether you believe memory chip prices will recover and new technology will drive further demand for innovative memory solutions. We believe this will occur as inventory eventually balances demand and new technologies emerge requiring better memory capabilities. Micron, with its healthy balance sheet, impressive cash flow generation ability, stock buybacks, and solid leadership at the CEO level are in a prime position to reward shareholders over the coming years.
Great Compounding Rate of Return on Invested Capital
Here’s how we determine that Micron has compounded its intrinsic value at a 60% rate over the past 7 years.
Intrinsic Value Compounding Rate = Incremental Return on Invested Capital * Reinvestment Rate
Pre-tax earnings 2012: -754
Pre-tax earnings 2018: 14,307
Capital invested 2012: 11,398 (Total Assets – Goodwill & Intangibles – Excess Cash)
Capital invested 2018: 35,015 (Total Assets – Goodwill & Intangibles – Excess Cash)
Capital invested can be thought of as all forms of capital such as debt and equity required to run the business.
Cumulative pre-tax earnings from 2012-2018: 25,095
Reinvested earnings = Capital invested 2018 – Capital invested 2012 = 23,617
Reinvestment rate = Reinvested earnings / Cumulative pre-tax earnings from 2012-2018 = 94%
Return on incremental capital invested = (Pre-tax earnings 2018 – Pre-tax earnings 2012) / ( Capital invested 2018 – Capital invested 2012) = 63.8%
Intrinsic Value Compounding Rate = ROIC * Reinvestment Rate = 63.8% * 94% = 60%
As we can see, Micron has invested most of their earnings back into the company and has been able to successfully earn high returns on those earnings! The question is whether it can continue to do so.
- At current price of $42.90, you’re paying about 8 times free cash flow for the last 12 months. 70% of the $3.8 billion in free cash flow was used to buy back stock YTD. (67 million shares)
- EBIT / Enterprise Value (enterprise yield) of 24% based on TTM EBIT and trailing P / E of 5.01 is compelling if you believe earnings are at a trough point and will recover.
- Healthy balance sheet and significant reductions in CAPEX and production for FY 2019 and 2020 should help retain profitability while industry supply / demand comes into balance.
Other Key Points
Micron, being one of only three companies providing most DRAM in the world, puts it in a strong moat position, with the ability to keep margins high.
Long-term demand outlook for memory and storage is excellent with advancements in artificial intelligence, 5G, cloud computing, smartphone technology, advanced cameras, autonomous vehicles, and more.
Management confident that bit demand for DRAM will return to healthy year-over-year growth in the second half of calendar 2019.
Management says US tariffs on imports from China were less than 30 basis point impact to gross margins, and that they have successfully mitigated approximately 90% of the impact from tariffs.
Micron recently determined they could legally resume shipping a subset of products to Huawei, mitigating the revenue loss from their biggest customer.
Any improvement in US-China trade relations will be positive for Micron. A major sticking point in talks has been the blacklisting of Huawei by the US. We believe that the current US administration will want to strike a trade deal with China before the 2020 presidential elections so as to be seen as having a “win”. We think the chances for a trade deal and a partial de-blacklisting of Huawei are high before November 2020. This will be a positive for Micron.
Shares sold short as a percentage of float only around 4%. Since short money is usually smart money, we consider this a positive.
1. Both the DRAM and NAND markets remain over-supplied. This could persist longer than management expects, keeping memory prices low.
2. US-China trade relations may take longer to fix than expected, and Huawei remains blacklisted. As Huawei is Micron’s biggest customer, this will put a strain on earnings.
3. Inventory could continue to accumulate in Micron’s balance sheet if customers can’t work down their inventories resulting in potential write-offs.
4. China, with its $20 billion Integrated Circuit Industry Investment Fund encouraging the development of memory chips, could break into the memory market. If Chinese companies start developing memory chips on a large scale at low cost, this could collapse memory prices and hurt Micron’s earnings.
Company and Industry Overview
Micron makes memory chips, mainly DRAM and NAND, that keep smartphones, tablets, cloud computing servers and other devices running. Three companies in the world represent pretty much the whole market for supplying DRAM. They are Micron, Samsung, and SK Hynix. Micron holds about a 21% share for DRAM and is the only one of the three based in the US. In NAND, in which there are more competitors, Micron holds about a 13% share.
Without getting into too much detail, DRAM is short-term memory that’s fast but the contents erase once a power source isn’t connected whereas NAND is long-term storage memory that’s slower but retains its contents even if power isn’t connected. Micron gets about 65% of its revenue from DRAM and 30% of its revenue from NAND.
Memory chips are considered commodities in that there’s little differences among them, so they go from under to over-supply and are subject to cyclicalities in their demand. Therefore prices go through boom and bust cycles. They’re currently in the downward leg of their price cycle due to oversupply and slowing demand, but there’s signs prices are leveling off and near the trough of the cycle, at least according to Micron’s management. Needless to say, the downward cycle has negatively affected Micron and other memory makers’ stock prices, with Micron going as low as $29 in December 2018 from its peak of $65 in June 2018, a decrease of 55%. Since its recent low however, the stock has recovered to $42.90, a 48% increase, after the market perhaps realized the worst is over for chip stocks and a bottom for memory prices has been reached.
With continued growth in computing power, the need for memory chips will only increase in the years ahead. Autonomous vehicles, artificial intelligence, smartphones, and cloud computing servers, for example, will require massive and efficient storage space for the amount of data created. Micron, as a pure-play memory company, and one of only three companies providing DRAM, is in a unique position to take advantage of this growing trend.
The fact that Micron is completely reliant on sales of memory, (as opposed to Samsung and SK Hynix, which are larger conglomerates that could subsidize losses from their memory business from other divisions), could actually be an advantage to Micron. It means that they have to be at the forefront of memory technology, providing the best in class products, and being able to lower costs as much as possible in downturns.
Case in point: Micron, in collaboration with Intel, created a new type of memory called 3D Xpoint, which is faster than flash but cheaper than DRAM. It’s patented technology, so if successful, customers will only be able to buy it from Micron.
With few competitors in DRAM, profitability has been higher in this area, with gross margins averaging 37% over the last 5 fiscal years, hitting a high of 59% in FY 2018. However, they are expected to drop to around 29% for the 4th quarter of FY 2019.
Some Company Stats
64% of overall company revenue in FQ3-19
▪ Revenue down 19% Q/Q and down 45% Y/Y
31% of overall company revenue in FQ3-19
▪ Revenue down 18% Q/Q and down 25% Y/Y
~8% reduction in outstanding shares since FQ3-18
70% of ~$3.8B in free cash flow used for repurchases YTD
% increase from recent low of $29 in Dec. 2018 = 47.9%
% decrease from recent high of $64.66 in June 2018 = -33.7%
Issues to Monitor
A potential threat to the profitability of the memory market at some point in the next several years could be China, with its $20 billion Integrated Circuit Industry Investment Fund encouraging the development in China of memory chips. They could potentially flood the market with cheaply priced memory chips and cause a collapse in profitability. At present however, China imports mostly all of its memory chips and exports very little, and we don’t expect that to change in the near future. Although they could enter the market, it’s most likely many years away, and the transition won’t be seamless. China has to build the plants, hire the talent, and develop the technology that’s on a par with the quality of what Samsung, SK Hynix, and Micron are putting out right now. It won’t happen overnight, but it’s something to monitor.
Trade tensions between the US and China are a further risk to Micron’s profitability, although at the present time, the effect to Micron has been miniscule. Huawei, Micron’s biggest customer, representing about 13% of sales, has been blacklisted by the US. Micron CEO Sanjay Mehrotra noted that Huawei was Micron’s No. 1 customer and that the ban cost the company about $200 million in missed sales during the third quarter. Micron hasn’t been able to ship certain products to Huawei. However, they determined they could lawfully resume shipping a subset of current products that are not subject to Export Administration Regulations and Entity List restrictions.
Micron is also benefiting from the leadership of a great CEO in Sanjay Mehrota. He was co founder of SanDisk and when it was acquired, joined Micron in 2017. He brings 30 years of experience in the semiconductor industry to Micron. He used 70% of their $3.8 billion in free cash flow to repurchase shares year-to-date, resulting in about an 8% reduction in share count since last year. The repurchases, occurring during a cyclical trough at low stock prices is a wise capital allocation strategy. We wish more CEOs would buy back stock at cyclical lows instead of highs.
– Memory prices recover as customer inventories wind down.
– New technology spurs demand for better memory solutions.
– US-China trade relations improve before 2020 elections and Huawei gets de-blacklisted by the US.
RTN Investments holds a position in Micron stock. This article is not meant to be investment advice. Do your own research before investing.
Robert Nowak is the founder of RTN Investments, LLC. RTN is a registered investment advisory managing separate accounts for clients and is modeled after Warren Buffett’s original partnerships. RTN’s goals are the preservation of client’s capital and to outperform the S&P 500 on a rolling 5 year basis by investing in undervalued stocks of high quality companies.