Micron Technology: Ragtop Redux - Seeking Alpha

With the heady 4.5% average daily price appreciation in Micron Technology (MU) stock thus far in 2018 (two days worth!), investors are giddy. Some may have even annualized this daily rate and are drooling over the implied ~1200% annualized rate of return if we keep going at this rate all year. Yes, I've enjoyed it also and have made a quarter's worth, or a year's worth, of return in a couple of days.

But before we pat Ernie Maddock (CFO) and Sanjay Mehrotra (CEO) on the back and relax, please consider the poor job they are doing rectifying the easily fixed sins of their predecessors. This article reviews the convertible debt portion of the balance sheet and offers up an easy score card by which we can grade management on dealing with this problem.

History. Former Micron Technology CFO, Ron Foster, issued billions of dollars worth of toxic convertible securities and hedged them poorly. I first wrote about this train wreck in April of 2014. Apologists say that this was the only finance possible to secure the Elpida transaction. Bunk! Micron had ample support from Apple (AAPL) to do that transaction, and probably could have gotten additional support given Apple's voracious appetite for memory. The passage of time has shown Intel's (INTC) renewed interest in memory. Intel helped Micron a lot with the establishment of IMFT (Intel Micron Flash Technologies) but they probably could and would have helped more. Straight debt, instead of convertible debt, was certainly a possibility albeit at junk rates. One wonders whether a Japanese debt issue would have been a possibility given the huge interest we have recently seen in the Toshiba spin off. But Foster and a demonstrably financially illiterate board kept going - even with Elpida in the bag - and did a further issuance of convertibles (the 2043 tranche issued in November 2013 months after Elpida closed) in part to pay off other convertibles!

There was a credible effort in 2014 and 2015 to deal with these convertibles in a decisive way via large restructurings.

Here's the very credible effort undertaken in 2014:

Throughout 2014, we reduced the dilutive effects of our convertible notes by exchanging, converting or repurchasing a portion of these notes using cash generated from operations and proceeds from issuing non-convertible debt with near investment-grade covenants. Approximately 90% of our free cash flow (cash flows from operating activities less expenditures for property, plant and equipment less payments on equipment purchase contracts) generated during 2014 was used for these dilution-management activities. As a result, we eliminated convertible notes that would have been converted into 118 million shares of our common stock. (Author's emphasis added. Quote Source: Page 40, 2014 10K).

Here's a disclosure on the blood bath taken to deal with this issue in 2015:

In 2015, we consummated a number of transactions to restructure our debt, including repurchases, conversions and settlements of convertible notes, and the early repayment of a note. As a result, $489 million of aggregate principal amount of our convertible notes was settled for $1.43 billion in cash. The liability and equity components of the repurchased convertible notes had previously been stated separately within debt and equity in our consolidated balance sheet. As a result, the repurchases, conversions and settlements decreased the carrying value of debt by $686 million (including $275 million for the fair value of our derivative debt liability to settle the conversions entirely in cash) and equity by $691 million. In connection with these transactions, we recognized aggregate non-operating losses of $49 million. (Source: 2017 10k page 61)

Indeed former VP of Investor Relations, Kipp Bedard, called dealing with the convertibles "...one of the finance team's higher priorities." As this comment to a SA article indicates:

Bruce Burnworth, Contributor

From Kipp: "We have over 2 billion of outstanding convertibles and the issue we have to keep our eye on is that for every 2 dollars in stock price increase it's cost us and our shareholders 400 million additional to retire the converts. Minimizing the dilutive effect of these converts is still one of the finance teams higher priorities."

7 Apr, 09:46 PM [author's addition: 2014]

Alas the pace and priority of 2014 and 2015 dissipated. The stock sank (a great time to retire converts owned by formerly happy holders). Foster left. Ernie arrived. And not much happened on retiring convertible debt. And now the stock is roaring along with the convertible dilution once again rearing its ugly head and the poorly designed hedges nearing expiration.

Where are we now? Here is the listing of convertible debt from the 2017 Form 10k page 59:

But in the upside down, Alice in Wonderland world of GAAP accounting, the carrying value doesn't include the all important "Conversion Value in Excess of Principal." Here's what that whole enchilada looked like as of the fiscal year end:

Maturity	Total Carrying Value (millions of $)	Conversion in Excess of Principal (millions of $)	Real World Total (millions of $)
2032C	211	519	730
2032D	159	390	549
2033E	202	332	534
2033F	278	572	850
2043G	671	99	770
TOTAL	1521	1912	3433

Lets just ignore the fact that the 10k shows the "fair value" at $3.901 billion which should equate to the carrying value plus the conversion in excess of principal, the $3.433 figure at the lower right of the table. Chalk it up to EP's confusion on disclosure or the wonders of GAAP. I believe the difference between EP's "Whole Enchilada" accounting of the right hand column of the table immediately above and the "fair value" accounting of 10k's and 10Q's is the option value. The Whole Enchilada of the right column is the "intrinsic value" of a convert and the "fair value" includes some option value or time premium given the long while until these issues mature? Again, low marks for Micron's disclosure. If they don't want to use the footnotes to the 10Ks and 10Qs, how about the quarterly slide deck which takes a tiny step to talk about convertible dilution (see below)?

Confused enough by the various debt levels? Confident that the $1.521 billion carrying value reflected on the company's consolidated balance sheet is the right one? Or are you bothered by the "Conversion in Excess of Principal", EP's "Whole Enchilada" number or the even higher "fair value"? How about throwing them all together and including market value (something SA readers and institutions care about and understand):

	interest	10k	conv in	whole	4-Jan	whole issue
tranche	Rate	carrying	Excess	enchilada	quote	@ quote
2032C	2.38	211	519	730	482.768	1,019
2032D	3.13	159	390	549	453.363	721
2033E	1.63	202	332	534	390.250	788
2033F	2.13	278	572	850	408.000	1,134
2043G	6.76	671	99	770	156.006	1,047
		1,521	1,912	3,433		4,709

(Last Sale pricing from Morningstar)

By the end of the first quarter, the carrying value and the fair value were the following (See 2018 1Q 10Q page 15):

The takeaway here is that sell side analysts, looking at valuations based on book value, are ignoring the very real liability of "Conversion in excess of Principal." Also we have a big and growing problem, as these snapshots show:

	conversion in
	excess of
	Par
	(Billions)
2018 1Q	2.87
2017 10k	1.92
2016 10k	0.527
2015 10k	0.553
2014 10k	2.99

Every quarter we are served up a "Convertible Notes Dilution Overview" table like this one:

Hmmm. With sell side price targets ranging as high as $75, why does the table stop at $50? I'm not invested in the stock for a run to $50 and suspect most SA readers and the large institutional investors aren't either.

Take a look at the "Benefit from Capped Calls." Why is that number going down as the stock price goes up? Where's the disclosure on that, Ernie? What happens if you extend this table out to the right where a lot of the analyst price targets are now clustered?

A main takeaway is that the dilution from these convertible bonds increases 2 million shares for every $1 the stock price climbs.

Here's some of the paltry disclosure on the capped calls:

My takeaways are several: 1) Note the paltry amount of the Maximum Value at Expiration - $527 million compared to the total of the converts. 2) note that the largest tranche of converts, the 2043G, is apparently totally unhedged. 3) We have only a couple of years of protection for issues with much longer maturities.

A current oddity. I had a lump in my throat and high hopes when I saw a news headline on a debt redemption, financed by a $1.2 billion stock offering. Surely this would be convertible debt they were finally removing? Alas, this dilutive offering wasn't used to remove dilutive convertible debt, it was aimed at a straight debt issue as the press release explains:

Micron expects to use approximately $476 million of the net proceeds from the offering of common stock to redeem approximately $438 million in aggregate principal amount of its 7.500% Senior Secured Notes due 2023 and pay accrued and unpaid interest thereon. Micron anticipates that it will use the remaining net proceeds from the offering for the repurchase, redemption, retirement or other repayment of its outstanding debt securities, which may include any of its senior notes, senior secured notes or senior secured Term Loan B notes, and general corporate purposes

Great! We've retired the highest price piece of debt saving a couple of percentage points in interest over what would have been the result if the proceeds had been used to retire one of the tranches of converts. Ernie has retired some straight senior debt while the clock ticks away with 2 million additional shares of dilution from the converts for every point upward the stock moves!

Scorecard and Prescriptions. Enough of the history lessons. Let's get after the problem once and for all. Here are some ideas:

1. Buy back sufficient Treasury Stock and set it aside to deal with projected conversions. As shown above each additional point on Micron's stock price produces about 2 million shares of additional dilution from the convertible debt, per the company's quarterly disclosure.
2. Align additional equity grants to finance staff and the board with this convertible related dilution. Benchmark grants in part based on taming this dilution. I favor a carrot (additional grants if this issue is put to bed) and stick (grants are trimmed or revoked if convertible dilution continues unchecked).
3. Issue additional straight debt specifically targeted for funding a Dutch auction to entice the retirement of non-callable converts. Yes, some holders may get taken out at a premium to market but the accompanying dilution with those bonds will be gone forever. Along these same lines consider straight debt swaps with these convert holders.
4. Beef up the board and financial staff with personnel qualified to deal with fixing this wound in the capital structure. I have long favored having Sanjay hire his brilliant CFO from SanDisk, Judy Bruner, either on the finance staff (as CFO?) or on the board. Judy issued converts at SanDisk and her disclosure regarding them was a model of clarity, as opposed to the muddle that Micron serves up.
5. Properly hedge these issues as the existing capped calls expire. The protection in place doesn't match the long tenor of the underlying issues or match the size of the potential hole in the balance sheet. Don't return to the investment banks and derivative desks that did the original issuances and derivative hedges, which are still howling with laughter at their counter party Mr. Foster. (I've met alumnae of the derivative desks that did these trades. Their continued glee is nauseating.) Put it out to bid to a number of banks and hedge funds and get a blue ribbon team to evaluate the proposals.

Conclusions. Many SA commenters wonder why the company only gets a PE ratio of around 5x. Examples like this unchecked convertible dilution annoy the heck out of institutions. Micron doesn't act like a $52 billion market cap company closing on $30 billion in revenue. If the company were to adopt and announce a five-point plan like the one above (as augmented by other SA commenter's ideas), they'd get a bump in valuation and get some skeptical institutions believing the story. I flagged this issue almost four years ago. Lets get after it!

Disclosure: I am/we are long MU, INTC.

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.

http://ift.tt/2AuKqTq