Micron: Don't Buy The Breakout - Micron Technology, Inc. (NASDAQ:MU)

MU shares have been moving higher lately. This upward momentum in price action has been driven by a Q3 report that was "strong."

Previously, Sanjay Mehrotra, the company's CEO detailed his vision on CNBC to keep capex relatively steady. Now the company has guided to slash capex, bring supply and demand more in-line.

Despite my more pessimistic tone short-term, the long-term fundamentals of MU, and memory overall remains solid. Robust end markets, 3D XPoint, and a strong buyback plan are all good aspects of the bull case.

Rating reiterated at HOLD, waiting for far more attractive entry point that accounts for the risk in the stock.

One of the great opportunities we frequently see in the markets is when, for a brief snippet of time, the market acts fundamentally irrational. In these occasions, a company delivers a better than expected quarterly print, but the stock moves lower. Or the opposite happens, where the numbers are worse than expected, but the stock moves higher. I have noticed such situations in the past, particularly with tech stocks.

In Micron's (NASDAQ:MU) case, I believe the market has moved irrationally over the last few days in reaction to Micron's fiscal Q3 numbers and Q4 guidance. Lets look at the good in the quarter.

We'll dive into the rhetoric later, I'm just looking at purely the numbers right now. With that being said, lets look at the nearly abundant negative news distributed.

As you can see, it appears that the results from this quarter were good, with Micron delivering a solid top and bottom line beat. But as we look at both the gross margin and EPS guide for the quarter, a different story is told. These numbers are down right atrocious.

So, investors are bidding up the stock based on current numbers. It doesn't seem like they cared much about the substantial miss on their guidance.

As much as management touts a back-half recovery, inventory levels remain quite bloated. This is the key reason that Micron, as well as its competitors, are idling some of their production. Cutting back on supply allows supply/demand to normalize. But Micron appears to be late to that party. Over the last couple of quarters, Micron has been minimally scaling back its capital expenditures. Meanwhile, the industry seems to be quickly reducing capex, to help clear inventory, and most importantly, stabilize pricing.

At the end of the day, pricing is what drives Micron's business. Lowered pricing if not balanced with higher volumes, will lead to lower revenues, margins, and earnings.

Inventory itself is important. More important however, is the pace at which Micron is clearing its inventory. While management continues to tout a story of improving inventory levels, look at how long its taking to clear inventory.

As you can see, despite management's rhetoric about a recovery in the back half, it seems like things are only getting worse quarter after quarter. It doesn't help that a ban was just imposed on Huawei products also. For those that don't know, Huawei makes up 13% of total revenue. So its safe to say Huawei is a large customer. While Micron has found some ways around this ban, the ban on Huawei products has not helped Micron's supply chain.

While Micron is indeed idling 5% of wafer starts in DRAM, and 10% of wafer starts in NAND, thus cutting back supply, this inventory problem is not solved in one or two quarters. While I had previously anticipated some kind of back half recovery, it now appears unlikely.

In cyclical businesses like oil and memory, pricing truly dictates everything from revenue to gross margins, to the bottom line as a whole. As supply is cut, pricing is supposed to improve. However, that negatively impacts the volumes. Higher pricing with lower volumes yields a much lower top-line and worsening operating leverage. As such, analysts continue to take down their revenue estimates. Meanwhile, Micron is not lowering its operating expenses fast enough to offset eroding gross profitability.

All of this leads to a downward spiral in profitability. Eventually, this reduction in profitability will come to an end, but until then, new management initiatives like their share repurchase program are under threat.

Until Micron and the rest of the industry sees pricing stability, it will be difficult to predict a bottom in both the EPS and the stock.

Huawei makes up 13% of Micron's total revenue, while China makes up roughly half of Micron's total revenue. So, it is safe to say that trade war news, whether it be positive or negative, makes an impact on both the business and the stock price. Simply put, China/Huawei drives price action.

Until we get a clear cut trade deal, rather than the rhetoric and tariff delays we are getting right now, China heavy companies like Micron are nowhere close to being out of the woods. So until concrete progress is made on both the Huawei situation and the Chinese trade war, China is a cloud looming above Micron.

There are a few facets of the Micron bull story, and a few facets of the Micron bear story. We will start with the story for long-term Micron bears, then move on to the story for long-term Micron bulls.

Regarding the oligopoly, both bears and bulls use the oligopolistic industry as a talking point. For the bears, the oligopoly introduces risk. We have to break this down between DRAM and NAND.

In the DRAM market, there are four main players: Micron, Samsung, SK Hynix, and Nanya. Nanya is a more negligible player in the space, with only ~4% overall market share.

In NAND, the market is far more diversified. Micron, Intel (NASDAQ:INTC), Toshiba, Western Digital (NASDAQ:WDC), and SK Hynix are the main players.

So, in NAND and DRAM, Micron has four and three competitors respectively. While in theory, the less competition the better, Micron is a different kindof company. While less competition means greater market share, less market participants can have some negative ramifications on the overall state of the market.

How? Because there are too few players in the overall space, it means a move from any individual producer can have a drastic effect on the overall market. For example, if Hynix idles a DRAM production wafer, the supply of the entire industry will be cut down. The seemingly small and unimportant maneuverings of an individual firm has drastic ramifications for the overall market, thus the other participants. So the seemingly unimportant actions of one participant can have severely negative consequences for other companies in the industry.

So, Micron and other companies try to keep trends in their business model in-sync so to speak, to avoid severe volatility in the industry. Recently it seems the memory industry, with Micron in particular, seem to have been caught off-guard regarding the velocity of memory pricing reductions.

So, most of the time, the less competition the better right? Well, the memory market oligopoly can also have some fairly significant negative ramifications.

The next element of the Micron bear case is by far the most touted. Micron, and the memory market, are cyclical markets. There are boom cycles and bust cycles. The time to buy Micron stock is during the busts. The time to sell is during the booms.

These swings can be quite severe. Lets look at calendar 2018 versus estimates for 2019 and 2020.

While eventually the business inevitably bottoms out at the bottom of the pricing cycle, the company will likely never be a steady state one. Instead, the company will be fluctuating in and out of profitability. So, it is difficult to value the business based on purely profits or cash flow. Rather, the business should be valued on a more steady state metric like tangible book value.

I briefly touched on the last tenet of the Micron bear case when discussing the business' cyclicality. It has to do with the idea of a value trap. A value trap is a company whose stock is socheap that it lures in investors looking to invest in its "value".

But, as we have seen, this low valuation appears to be a trap. Why? The earnings are simply not stable enough. On 2018 EPS numbers, Micron shares appear cheap at just ~3.5X earnings. A screaming bargain, right?

Well, two years later, the cyclicality of the business squeezes margins, reduces revenues, and hurts this lucrative EPS number. Now, Micron trades at ~16.8X 2020 EPS estimates. Micron isn't such a screaming bargain anymore.

This is one of the biggest problems for the Micron bull case. The profits are just not stable. So, when the stock gets down to 3.5X earnings, it is probably close to the top of the chip cycle.

Let's start with the share repurchase plan. A while back, Micron's management, led by CFO Dave Zinsner announced a massive $10 billion buyback plan. Specifically however, Micron announced they were devoting 50% of free cash flow buying back shares. Previously the company was generating record levels of free cash flow that would have enabled better execution of this buyback program.

Now, as EPS turns downward so does free cash flow. Free cash flow at the end of the day is what enables this $10 billion buyback program.

While the buyback is a long-term tailwind for EPS and the stock price, because FCF is being reigned in, we might see sluggish execution of the program short-term until FCF recovers.

The second part of the long-term bull thesis regards the company's long-term demand picture when it pertains to new end markets. In theory, these developing end markets like artificial intelligence, the cloud, autonomous driving, and IoT all require significant amounts of memory. This will lead to an expansion in demand. This could lead to an eventual stability in Micron's business, even a march towards a growing Micron rather than a cyclical one. This is the most important tenet of the bull thesis, as it the most long-term focused tenet. These new technologies are definitely memory intensive. As these markets grow, so will the need for memory, thus positively impacting Micron's business.

The final piece of the bull thesis regards Micron's next iteration of memory technology. For the the first time in decades, a new memory architecture, 3D Point has been created and will likely be entering manufacturing some time soon. In terms of performance and efficiency, 3DXP has been considered in between traditional flash memory and DRAM. So it will not be as large a market as DRAM. The thing is though, this is proprietary Micron-exclusive technology. The development of 3DXP initially started as a collaboration with Intel under a joint venture called IM Flash Technologies. Recently however, Micron bought out Intel's stake in IMFT, granting Micron basically a monopoly in 3DXP tech. This means Micron can singlehandedly control this part of the memory market, giving them greater control of bringing supply and demand into equilibrium. This means they could control pricing and margins, a level of control they don't have in their current NAND and DRAM markets.

First of all I am not a financial advisor. Everything expressed in this article is my own personal opinion. I am not long Micron at ~$44, and have no desire to be long the stock at this price right now.

Considering the state of the market, continuously reaching new highs, I would wait for a broader pullback before getting into Micron stock. In terms of where I would consider buying Micron shares, I will say this:

Book value per share sits at $32 right now. If the state of the company continues to worsen, or if the markets overall turn down, then $32 is the level I would be watching as an entry point.

Long-term the fundamental story is solid, and I believe Micron will overcome. However, now is not the time to be buying Micron shares.

In the last month, Micron shares have rallied hard, up a staggering ~37%. For what reason? Has the business fundamentally improved? Has the industry overall bottomed? No and no, at least in my view. Micron's ever ballooning inventory pile is a severe risk to the prospects of the business short-term. That being said, I like the long-term fundamentals of the company, we just need to wait for a bottom in the cycle before I buy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice. Please do not interpret this article as financial advice. I am not a financial advisor.

Source: Seekingalpha.com

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