Micron (MU) - Get Micron Technology Inc. Report has had a very volatile 2019, as traders have attempted to time their entry into the stock. But when all was said and done, the stock has delivered a roughly 50% return, by far outperforming the S&P500's 25% increase over the same time frame.
Micron reports its Q1 2020 results on Wednesday, Dec. 18 after hours. Meanwhile, Micron’s stock is way too cheap to remain at this price for much longer. Here’s why:
The Biggest Driver For Micron
Micron manufactures high-performance memory and storage technologies. This is a sector that historically has been very cyclical. Presently, Micron faces the bottom of its memory cycle. But a few notable aspects are different from previous cycles.
This cycle’s hangover is expected to be nearing the end, but more importantly, the demand for memory in artificial intelligence, 5G, machine learning, and autonomous vehicles is like nothing we have witnessed before.
In fact, even the most bearish analysts acknowledge that there is going to be a huge secular demand for memory, with the only point in contention being the timing of the recovery. But given that investors are forward-looking, any good news should see this terrifically undervalued stock rapidly appreciate in value.
As a reminder, Micron sells both DRAM and NAND chips. DRAM memory chips are far more advanced and offer better profit margins than NAND. DRAM is only produced by a small number of players on a large scale, namely, Micron, Samsung (SSNLF) , and SK Hynix.
NAND memory is more commoditized, with numerous players possessing the know-how to manufacture these memory chips, resulting in unimpressive profit margins.
But the thing to note, which is rarely discussed, is that Micron’s revenues are more than 60% derived from DRAM chips. And given that DRAM has much higher profit margins, its impact on the company’s health carries significantly more weight.
The All-Important Guidance
For now, investors have been consumed with U.S-China trade fears and the implications that the U.S. ban on selling to Huawei is likely to have on Micron’s revenues.
The Chinese telecom giant accounts for approximately 10% of Micron’s total revenue, and according to the latest reports from Micron, the company has not yet received the green light from the Commerce Department to ship to Huawei for its larger, more material contracts.
Thus, even though there still remains uncertainty on when Micron’s ability to trade with Huawei takes place, the bigger element at play should be on whether the DRAM cycle is finally bottoming out. And for this, investors will have to tune in to its earnings call on Dec. 18. Any good news from Micron on the DRAM space and the shares are likely to reprice higher.
According to Micron’s previous guidance, for, Micron had expected to see some vitality in its DRAM business in early calendar 2020. The number to watch out for here is Micron’s inventory days outstanding. Last quarter’s figure stood at 131, and if this number were to remain high, investors would take a cautious view on Micron. But if this figure comes down, even slightly, this would imply Micron is succeeding in shipping its product and avoiding the risk of inventory obsolescence.
Valuation - Huge Margin of Safety
On most trailing metrics, Micron's stock is irrationally cheap.
But the question which matters most is when will the DRAM cycle truly bottom out?
For now, Micron’s management has exhibited restraint by opting to strengthen its balance sheet rather than being overly aggressive with its buybacks. This has allowed Micron to increase its net cash position to $3.4 billion. Having said that, during fiscal 2019 (up to and included the latest reported quarter), Micron repurchased $2.7 billion worth of shares, representing 7% of its outstanding shares, or 66% of its adjusted free cash flow.
Hence, looking further ahead, if Micron is able to generate approximately $4 billion of adjusted free cash flow during a down cycle, just how much will it generate once the cycle starts to stabilize? Could it generate $5 billion of free cash flow or even more? Note, during fiscal 2018 Micron’s adjusted free cash flow was as high as $9 billion.
Consequently, any way an investor appraises Micron, it likely to be trading for roughly 10x-12x forward depressed free cash flow. Once conditions stabilize, Micron may even start to deliver positive surprises. And this valuation will be way too cheap.
The Bottom Line
As Micron goes into its Q1 2020 earnings next Wednesday, the stock remains incredibly cheap. With too much negativity priced in, the stock should be strongly considered as part of a well-diversified portfolio.
The author is long MU.