For a large part of calendar 2019, Micron had been plagued with uncertainty as to when exactly its environment would improve.
Micron had been stating that the cycle would improve towards the end of calendar 2019 but that didn't happen. Then Micron said that towards the start of calendar 2020 there would be an improvement, and that doesn't appear to be happening either.
But now we finally know, the bottom of the memory cycle is likely to have been reached and its guidance is looking promising.
Nevertheless, for now, the stock remains way too cheap, for now. Here's why:
Balance Sheet Is Vastly Improved
CEO Sanjay Mehrotra and his team have a reputation for being prudent capital allocators and managing Micron's financial position with caution.
In actuality, I contend investors are failing to price in just how strong Micron's balance sheet has become of late. What's more, given S&P's recent upgrade of Micron's debt to investment grade, all three rating agencies now rate Micron's debt as investment grade
Thus, assuming that the cycle is starting to bottom out, which many indicators appear to point towards, then this stock is incredibly cheap.
On the other hand, we still don't know how strong the recovery is likely to be, which is another reason why share repurchases were not very strong in Q1 2020 (just $250 million including the convertible note redemptions).
Market Conditions Are Set to Improve
The talk on the earnings call last month was more confident than it has been for a while. Mehrotra is always highly confident, but this time, from Micron's earnings call we are able infer imply that conditions are now very likely to bottom out in Q2 2020, inflect slowly into Q3 2020, and then ramp up into Q4 2020. In other words, next quarter is now expected to mark the end of the pain for shareholders.
There Are Risks but Micron Is Cautious
Mehrotra's recent commentary notes that even though memory is highly commoditized, the number of new entrants is being restricted by the amount of capital one has to commit to even get started. Moreover, Mehrotra declares that the memory industry has even higher barriers of entry than many analysts believe.
Micron also asserts that although DRAM is commoditized memory, customer demand is becoming increasingly specialized, and therefore it requires steady innovation to be able to satisfy customers. This plays well for pure-play DRAM and NAND manufacturers, such as Micron.
Also, looking further out, 5G is expected to provide the sector with strong tailwinds, with demand for increased memory and content storage solutions.
Separately, chip equipment maker Lam Research (LRCX) - Get Report is also bullish on 5G technology and how increased communication will have a role in memory demand, thus providing a long secular tailwind to the sector.
Micron CFO David Zinsner notes that fiscal Q2 2020's guidance is pointing towards Micron's revenue being 60% higher than the previous trough of Q3 2016 -- reinforcing that Micron's present downturn is different from previous downturns.
Valuation - Huge Margin of Safety
Indeed we should acquiesce that no investment in a public company is made without risk -- particularly for a company with significant exposure to the economic cycle and technological advances.
With this in mind, I'm more inclined to think about the downside on this investment. Realistically, I think that Micron's valuation at approximately $65 billion is very cheap, particularly if we consider that even during the downturn, this company continues to be generating free cash flow. Sure, Micron could fall 50% in value, but this potential appears limited.
Looking into the next quarter, Micron trades for a hefty multiple to depressed earnings. But once Micron gets over Q2 2020 (next quarter) and starts Q3 2020 (six months down the road), the earnings will start to increase, and the multiple will decline and start to highlight the bargain opportunity.
However, investors shouldn't wait until this proof of validation. At that point, the stock will have rallied significantly already.
Micron is still very cheap at an approximately $65 billion market cap. How much free cash flow will Micron generate in its next calendar year, 2021?
It is difficult to know conclusively, but I would expect it to generate roughly $6 billion. At that point in time, investors will become highly bullish on Micron, and view paying north of $100 billion for it as a bargain opportunity.
Michael Wiggins De Oliveira is LONG MU