Markets are favorable for semiconductor corporations
There is no doubt 2017 was a good year for the semiconductor companies. Hence, the Semiconductor ETF (SOXX) increased more than 40% year-to-date, outperforming the broad market, and such companies as Nvidia (NVDA) and Intel (INTC) were in the winning positions. Thus, Nvidia stock almost doubled in 2017, and INTC started to grow significantly after a period of stagnation.
Micron Technology (MU) is not an exception here. In 2017, the demand for Micron's products and solutions remained strong, which resulted in stock climbing more than 100% YTD. As the company reported strong Q1 FY 2018 despite the unfavorable seasonality factor which usually affects this quarter, it can be expected the positive trend is likely to continue. DCF analysis supports this opinion, as the model shows the stock has room to grow.
Q1 FY 2018 was a favorable quarter for Micron
On December 19, Micron reported its Q1 FY 2018 results. The corporation's EPS amounted to hefty $2.45, which is more than 10% higher than the average of analysts' expectations. The historical earnings data looks even more impressive now, as the corporation continues to surprise the Street. Importantly, the increase in EPS was achieved organically (through core business activities), and even the fact that Micron issued additional stocks did not have a negative influence on EPS. This undoubtedly shows that the core operating activity was solid in the quarter.
As regards revenues, the company earned $6.8 billion in sales during the quarter, which represents a 71% increase year over year and 11% sequentially. This is especially impressive in light of the fact that Q1 tends to be a slow quarter for the company due to seasonality. As a result, a 35% revenue growth expected by analysts for 2018 seems to be rather conservative. I believe the corporation will likely continue beating estimates, given the overall market conditions will not change dramatically.
The success was primarily driven by the Compute and Networking Business Unit, as the revenue for this division doubled year on year and now represent about 47% of the total revenue. As the server market continues to grow, it can be expected Micron will gain from the trend along with other semiconductor corporations, such as Intel (INTC), AMD (AMD), and even Nvidia. Moreover, focusing on enterprise customers helped Micron increase its operating margin for the unit from 56% to 60%, which is important for any corporation that strives to generate value for shareholders.
Our record performance was driven by increasing server memory content, which drove higher sales to enterprise customers together with strong demand for graphics processing. Operating income was 60%, compared to 56% in FQ4 and 14% in FQ1 2017.
Other business units also demonstrated solid performance. Thus, Storage Business increased 61% year on year, reaching the level of $1.4 billion in revenue. It is claimed SSD sales reached the record level of sales in Q1 across consumer, cloud and enterprise clients.
The Mobile Business Unit also generated $1.4 billion, growing 32% year over year. The management stated the healthy-demand environment and new flagship smartphones launched during the fall helped the unit grow significantly. Moreover, the acceptance of LPDRAM products was strong, while the portfolio of the more traditional NAND (fast access, long-term storage) offerings remained on a secure position.
We are seeing strong acceptance of our LPDRAM products and continue to enhance our portfolio of managed NAND offerings. The solid demand environment, combined with the traction we've made with our latest-generation products, led to operating income of 37%, up from 31% in FQ4 and 9% in FQ1 2017.
The Embedded Business reported revenue of $830 million in Q1, which represented 32% increase year over year. Notably, automotive was one of the sectors that boosted the unit's performance in the quarter. It was emphasized during the earnings call:
We continue to see exciting demand trends across each of the underlying embedded markets with evolving end-market requirements ranging from high-performance memory required for autonomous driving, to ultra-high-density storage solutions for edge devices such as video surveillance cameras.
In my opinion, if Micron can capture market share in the automotive sector, especially in the autonomous driving technology, the corporation will gain from the industry significantly. This is because the number of "connected" vehicles is expected to increase rapidly, thus creating viable opportunities for tech companies. For instance, such players as Intel, Texas Instruments (TXN) and Maxim Integrated Products (MXIM) consider the auto market as a comprehensive source of revenue in the coming years. More about autonomous driving can be found in my article on the topic.
Overall, the corporation demonstrated stellar results across all segments. As a result of strong operating performance, the company improved its financial position. Thus, Micron's operating margin increased from 41% in Q4 to 46% in Q1 2018 on a non-GAAP basis. This enabled the corporation to generate healthy cash flow of $3.6 billion in FQ1, compared to $1.1 billion in the year-ago period. Moreover, the company "repurchased or converted" $2.36 billion principal amount of debt, lowering total debt to $9.34 billion in Q1, and now plans to lower the debt burden to about $8 billion by the end of FY 2018. This reduces the level of risk for investors, thus increasing potential valuation.
DCF modeling shows the stock has room to grow
To strengthen the analysis, I use discount cash flow model to value the company.
My analysis is based on the following assumptions:
1. The average annual revenue growth over the horizon period of five years is estimated to be around 17%, with a 35% increase in FY 2018 and 5% growth in 2019. I believe the assumptions are relatively conservative, considering the revenue grew more than 70% year on year in Q1.
The growth from 2020 to 2022 is expected to be on the level of 15%. The company's efforts on the enterprise market should allow the corporation grow in the coming years.
2. EBITDA margin will decrease from 45% in 2018 to 30% in 2022. This should provide a reasonable valuation for cautious investors, since the average level of EBITDA margin remains to be high in the semiconductor industry. Moreover, it was presented earlier that Micron is on right track in terms of growth of margins.
3. The average growth of gross PP&E of 15% will reflect a sharp increase in revenues and, therefore, should offset the level of depreciation.
4. The effective tax rate is estimated to grow over the horizon period of five years from the current 5% to a more conservative level of 20% by the end of 2022.
5. Then goes the WACC.
The after-tax cost of debt is 3.8%. The cost of equity capital (18.3%) is calculated using CAPM, with 1.77 beta, 2.4% risk-free rate, which is the current U.S. 10-year bond yield, and 9% market premium. The WACC is, therefore, estimated to be 16.3%.
The sensitivity analysis shows a range of possible outcomes that will be driven by actual results of the corporation. In light of this, the fair price range is $46.2-51.6, which represents 4-16% upside potential.
Micron remains to be attractive for investment
Overall, Micron demonstrated stellar results in financial Q1 2018 and in full calendar 2017. The company increased its revenues from such product lines as DRAM and NAND significantly, which was driven by the strong demand in the market. The corporation's efforts to penetrate such markets as servers and automotive will likely boost Micron's performance in the coming years. If the broad market remains healthy and no major shock happens, it can be expected Micron will continue beat expectations in 2018.
The healthy operating results enabled Micron to reinforce its financial position. Hence, the corporation generated a significant amount of cash in the quarter, increasing its cash pile while also reducing the level of debt. This was achieved by higher margins, which is a positive sign for investors. As a result, the level of the overall risk for the company went down, providing cautious investors with a higher margin of safety. Therefore, despite the fact that MU stock has already increased about 100% over last year, the company remains to be a solid investment. This is supported by the DCF analysis, which indicates the stock still has room to grow.
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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.
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