Best Buys In The AI Race, Part III - Micron Technology - Seeking Alpha

To recap this series, we have analyzed two companies with heavy exposure to Artificial Intelligence through GPU chips and their attractiveness as an investment today. Both discussions are linked at the end of this article. In this portion of our deep dive into playing the AI market, we’ll analyze big data and the memory chip companies best positioned to profit.

Big Data is an Understatement

Enterprises around the world are embracing new business opportunities from the exabytes of data (10^18) that AI organizes into simple and understandable ideas. Consumers are benefitting from the convenience of information at their fingertips and automation through robotics and IoT. Vacuums can now sweep our kitchen floors while driverless cars constructed by robots whisk us around. Factor in Artificial Intelligence’s insatiable appetite for data to make this possible and the setup is a storage market that is expected to boom over the coming years. International Data Corporation (IDC) estimates the “global datasphere” will grow a mouth dropping 10x from 2016 to 2025.

Enterprises are drowning in data as they collect every bit of information from cars, machines, products, and even our devices. The more data collected, the more opportunity there is for AI to learn and present new opportunities and value. For the foreseeable future, data centers will store all that data for industries like Autonomous Cats, IoT, CRM, Healthcare and Research, Social Media, Financial Industries, etc. in NAND and DRAM storage. This is where Micron Technology’s (MU) products are positioned to thrive.

NAND vs DRAM

NAND is a type of non-volatile, or mostly permanent flash memory (think your thumb drive) and can be stored without power. Slow speed and tendency to wear out cripple this technology, but it has become very inexpensive. If you’re looking for speed and resilience, the more expensive dynamic random-access memory (DRAM) will meet your needs. Unfortunately, any loss of power will wipe DRAM data from its nano-sized transistors, so backup power is required to prevent loss of information. Both are considered solid state drives (SSD), with explosive data center growth ahead of them.

Image Source: Statista - Worldwide NAND Flash Market

What Share Price is Telling Us

MU reported earnings on December 19 and beat on both the top and bottom lines with total revenues up 71% y/y. This growth was primarily attributed to gains in market share and higher selling prices of both its NAND and DRAM products. A supply-demand imbalance has driven prices higher and should continue into 2018 before supply capacity increases into 2019. Managements Q2-18 guidance also exceeded analysts’ forecast. Analysts now call for 19.5% revenue growth into 2018 with a drop of -0.5% through 2019 as competition increases capacity to rebalance supply and demand. The stock jumped over 5.5% after the report before settling back down around $44 within the week.

Margins expanded to 55%, up 29 percentage points from the prior year quarter and EBITDA grew 46% y/y. Management’s focus on expense oversight and more profitable products is working to reduce spending costs and increase margins. Over the past four years, cost of goods sold and operating expenses have only grown 2.3% and 5.5% respectively, compared to revenue growth of 8.5%. This bodes well for future operating margins, but competition, CAPEX, and a more realistic tax rate may erode free cash flows. These potential headwinds have been conservatively factored into the following analysis.

Image Source: Excel table by Author with historic earnings, guidance from management, and future projections

MU continues to accumulate cash while retiring debt. This past quarter saw management retire $2.4B of long term debt while increasing cash to $6.0B. This is a good sign for MU and the reduced debt to cash spread has been factored into the implied share price in this analysis.

Supply-demand imbalances have allowed MU to sell products at higher prices to drive margins. Most recently DRAM margins climbed to 61.5% margins with NAND margins rocketing to 49%. Historically, margins have averaged around 35% combined. Management’s new focus on higher margin products, improved manufacturing efficiencies, and growing demand by data centers should keep prices inflated and margins elevated. We’ll assume 45% margins over the longer term.

Management forecasts an increase in CAPEX spending to $7.5B as Micron ramps up supply and new chip designs. Future CAPEX spending has been fixed at the historical average of 29% of revenues. Finally, management guided for mid-single digit tax rates and announced little benefit from the new tax plan into 2019. We’ll project taxes will incrementally rise to 20% by 2022 to represent a more conservative and realistic level in line with comparable companies, like Intel Corporation (INTC).

Based on this DCF analysis, the current market appears to only expect a 3% CAGR in revenues moving forward with reduced margins from competition and a significant contraction in free cash flows (FCF) from a more conservative tax rate of 20%. A little more digging is required to see if these expectations are reasonable or overly pessimistic.

Market Growth Opportunity

The Market

For the most part, storage chips are a commodity in a cyclical market. Rolling fluctuations in the supply-demand balance create dips and spikes in sales. Management is aware of the risks associated with the sector as stated in MU’s Q3 Risk Factors Presentation:

In some prior periods, average selling prices for our memory products have been below our manufacturing costs and we may experience such circumstances in the future.

This past year has seen demand from data center and enterprises greatly outstrip supply and drive chip prices higher. Demand has been pulled higher by data centers while production has lagged supplies. NAND specifically witnessed slower production with the new 3D NAND chips that could not keep pace with demand.

Historically, NAND prices have behaved elastic to demand and customers have simply switched to cheaper alternatives during price increases, like inferior HDD. However, data centers demand performance. 3D NAND provides a significantly faster storage solution with less than 50% power consumption which satisfies data center’s use requirements. This means customers have continued to buy NAND even as prices have increased, quite the opposite of price elasticity. We’ll stop there before going down this rabbit hole on NAND elasticity.

DRAM prices on the contrary have always behaved inelastic to demand and see customer demand regardless of prices. This is because DRAM is required to run new programs and maintain increasing performance standards. This means that Micron can capitalize on rising demand for its higher performing products even if the supply-demand balance eventually corrects itself.

Dynamics aside, if demand continues to outrun supplies, MU should see revenues and profits continue to accelerate in both product categories. We’ll look at supply-demand forecasts next.

The Growth

Q1 of 2017 saw NAND prices jump 26% in the spring before leveling off and maintaining elevated prices throughout the year. Pricing for DRAM more than doubled over these past 12 months due to increased demand. While NAND prices may start to contract as early as 1Q18, the supply-demand imbalance is not likely to fully correct until 2019 as manufacturers require time to ramp up capacity. Heavyweights Samsung (OTC:SSNLF) and SK Hynix (OTC:HXSCL) have already made over $20B in combined commitments to increase production. MU has its own plans for $7.5B CAPEX to increase capacity. These may reduce prices and revenues short term which is being factored into the stock, but let’s focus on the longer term.

Longer term, credit Suisse expects DRAM demand to outpace supply and grow 25 to 30 percent annually, more than double industry projections.

Image Source: Statista - Data Storage Supply and Demand Worldwide, 2009-2020

3D NAND specifically is expected to grow over 33% annually between now and 2022 by NVM Durance while StorageCraft Technology Corp believes the flash market will grow to $63B in revenues by 2024, an 18% CAGR. Regardless of opinion, the generally consensus is in support of strong growth in data storage revenues, well above the current market’s expectations of 3% annually.

In regards to cyclicality concerns (reference previous Historic Margin vs Share Price graphic), Spectra also seems to think demand will continue to outpace supply.

[There’s] a small likelihood of a constrained supply of storage to meet the needs of the digital universe through 2026. Expected advances in storage technologies, however, need to occur during this timeframe.

Sanjay Mehrotra, Micron’s President and CEO, agrees with the market demand outlook:

This is really a secular trend here in front of us in terms of driving continued usage of memory and storage.

This supports our assumption for a generally higher gross margin since Micron can sell chips well above cost in response to heavy demand. A positive sign for Micron’s margins and the sector at large will be if other companies provide similar statements recognizing lasting demand. This will give weight to the thesis that demand will continue to outstrip supply and pave a road for healthy growth ahead for Micron. Make sure to tune-in to this quarter’s earnings calls from DRAM/NAND market leader Samsung (release Jan 22), DRAM only market leader SK Hynix (Jan 24) and NAND only market leader Toshiba (late Feb).

All things considered, Micron is well positioned in a secular bull market for DRAM and NAND storage chips. As long as MU continues to develop cutting-edge chip designs on pace or ahead of the market, it should see DRAM and NAND sales exceed the market’s expectations. We’ll look at its products and future innovations next.

Products

MU segments its business into (1) Compute & Networking, (2) Storage, (3) Mobile, and (4) Embedded. Its storage platform represents data centers while Embedded encompasses autonomous machines. These two strategic business units represent 33% of current revenues with expectations to grow north of 50% as management focuses on these high margin SSD markets. This should bode well for MU's growth and margins.

Image Source: Micron Plans to Focus on Higher Margin Products

MU offers a broad portfolio of NAND and DRAM solutions. Per its 1Q18 Earnings Call, MU delivered record SSD revenues from data center shipments, increasing its market share. DRAM had solid revenue growth as well, delivering 50% y/y growth through both cloud and enterprise customers. Mobile, gaming and home automation continue to grow MU’s revenue, but we’ll continue focus on data centers and autonomous cars - hot beds of AI.

We have garnered solid interest from enterprise and cloud customers, and customer qualifications are underway... Cloud and traditional enterprise data center trends are continuing to drive robust demand for memory and flash storage solutions.

– Q1 2018 Earnings Prepared Remarks

MU unveiled the fastest high-density 32 GB NVDIMM-N for data centers in middle of November. NVDIMM is a module with combined DRAM and NAND that can permanently store data for supercomputing. We won’t know much about sales numbers until this quarter’s report in March. Looking further ahead, MU expects 64-layer NAND crossover in the second half of FY2018, meaning it is continuing to innovate by supplying higher capacity memory storage.

MU also announced the fastest memory chip for autonomous cars in its prepared remarks, a great sign for autonomous vehicle enthusiast:

…our announcement of the fastest 1X LPDDR4 and GDDR6 products for autonomous driving applications will ensure we continue to support this shift to leading-edge technologies.

The Future

To retain market share and at least grow with forecasts, MU will have to continue to innovate and launch disruptive new products. It happens to have one such product in co-development with Intel Corporation (INTC). 3D XPoint is a new form of non-volatile, solid-state storage with performance 10x faster in data storage than NAND flash, but for slightly less than 10x the cost. The technology fills a gap between NAND and DRAM to significantly boost performance of data centers. Instead of moving data to and from the processor, XPoint simply builds the processor into the memory around the data. Increased speed and resilience (1,000x endurance over NAND) make 3D XPoint an appealing add to the data centers.

Analysts including Gartner believe a significant uptake in data center use will occur in late 2018 and Micron sees a breakout year in 2019 revenues from the product.

This is an important technology (XPoint) that is going to have big implications for data center usage and to a lesser degree on the PC side. Whether it’s your hyperscale data center, cloud service provider or traditional enterprise storage customers, they’re all very interested in the technology.

Spectra believes Intel and Micron’s new 3D XPoint technology will drive storage capacity to the next level once 3D NAND reaches maturation. To add a cherry on top, Micro sells its 3D XPoint chips to Intel to repackage and distribute. Therefore, Micron has indirectly opened its doors to a multitude of new customers.

Conclusion

Based on the research, Micron appears to be well positioned with innovative products in a secular bull market. As long as the following three forecasts hold, MU should significantly exceed 3% revenues growth and warrant a higher share price: (1) demand must continue to outrun supply, driven by high volume data centers, enterprises, and innovations to prevent a significant cyclical decline in revenues (2) MU should continue to see above average sales prices to maintain margins at or above 45%, and (3) tax rates may gradually climb but not exceed 20% of revenues.

The following sensitivity analysis depicts where fair value may land based on various revenue growth and margins. This is assuming a drop in margin and conservative assumptions on R&D spend and tax rates. I currently see $48 as fair value with a buy at $42 and sell at $57. I may add to my position should things go south early next year.

Final Word

Before adding to any position, I like to check on the vitals of the economy to gauge potential recessionary risks. While long-term investors can use corrections to reload positions, recessions are damaging and painful. My preferred instruments of choice are the yield spread as discussed here, along with inflation, unemployment, GDP, and industrial production. The future is impossible to predict with certainty, but sometimes listening for the train whistles coming can help us get defensive and reduce odds of a significant portfolio hit. Currently, things sound fairly quiet for at least the next year.

Finally, for a quick read on playing the AI Revolution with highly popular GPU chips, here are the previously mentioned articles on Nvidia Corporation and Advanced Micro Devices.

Disclosure: I am/we are long MU.

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.

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