Micron stock will benefit from the structural changes in DRAM market.
Over the last couple of years, Micron Technology (NASDAQ:MU) stock has returned around 400%, handsomely outperforming the market. While the overall market sentiment has been conducive, the main reason behind Micron's astounding growth has been the remarkable improvement in fundamentals. In the last five quarters, year on year revenue growth has been above the 50% mark. The story is even more impressive on the profitability front with operating margin jumping from near zero to 47%. In the previous quarter, EPS grew by 247%. But despite this strong performance Micron stock continues to trade at a measly forward PE of 5x (for historical reasons). In this post, we will build a case for higher valuation multiple for Micron stock.
Micron's highly cyclical business
So, what is keeping the valuation in check? Historically, the semiconductor industry and more importantly the memory chip industry in which Micron operates has been notorious for its "Boom-Bust" cycles. The capital investment of the industry as a whole followed a ‘procyclical’ pattern. Add to it, both DRAM and NAND flash were commoditized and with price per gigabyte as the only prime differentiator. Whenever demand fell, players tried to gain an edge by slashing prices sharply, as the price was the main differentiator. The memory industry had around 30 players back in the 90s. The situation was made worse by the fact that memory players tended to run fabs at full capacity, even when demand dropped, in order to cover their fixed costs which were high. Price war in lean periods led to a massive decline in revenue as shown in the chart below.
The chart below plots the annual performance of Micron stock. Not surprisingly, Micron stock also behaved in a cyclical manner, giving outsized returns early in the cycle followed by low or negative returns as the growth phase ended. Investors are again worried that Micron's business cycle is turning and we are headed towards a lean period which could result in a massive correction if history is anything to go by. That is why Micron is trading at such ridiculously low PE multiple.
Structural changes in the industry
However, the fear of an impending slowdown is overblown. The industry structure has changed over the past decade. Boom-bust cycle led to a massive consolidation in the industry with three companies Samsung, Micron and SK Hynix controlling 95% of DRAM supply. DRAM contributes two third of Micron's revenue. Consolidation in the industry has led to better discipline in price and investment decisions. The capacity expansion has generally lagged the demand growth. Moreover, investments are being made in improving technology rather than just capacity expansion. The investment in more advanced technology will help them cut production costs and stay profitable even as prices ease. On the whole, consolidation has led to better pricing dynamics, improving margins and smaller peak-to-trough declines for the major players.
Earlier, the demand for DRAM was concentrated mostly in the PC market. But times have changed. PC sales are down. The decline in PC DRAM demand will be offset by strong demand from the mobile, tablets and server market. Micron has been shifting bit production towards the faster-growing segments from PCs.
With smartphone manufacturers increasing DRAM content on their high-end devices, DRAM demand will continue to remain strong. For instance, Android vendors now offer as much as 8 GB of DRAM on devices (as much as mid-range laptops).
Demand from the cloud computing market is also growing, as major internet players such as Amazon and Google build big data centers. Increasing server memory content will be a big source of demand. On the SSD side, the company expects the flash attach rate in servers to grow from 2500 GB in 2017 to 8000GB by 2021. On the DRAM side, the average server capacity is expected to grow from 145 GB to 300 GB. Trends such as machine learning, AI (artificial intelligence) and self-driving cars are also likely to boost memory demand over the medium term. In addition, unlike NAND, DRAM prices are relatively inelastic. Every device needs a certain amount of DRAM to meet performance requirements for systems which may have been in development for several quarters. All in all, the memory industry still has steam left.
Longer Business Cycle Should Lead To Higher Multiples
Structural changes in memory market (especially DRAM) and diversification of source of demand will lead to longer business cycles. The growth periods are going to be longer than earlier and peak to trough declines are likely to be smaller. Given this, there is a strong case for Micron to trade at a much higher Forward PE than 5x as the risks are much lower than what is priced in. A higher multiple will lead to price appreciation in Micron stock. Micron stock rally still has some steam left. A more reasonable PE of 7 would lead to about 20% stock price gain. Micron stock still remains a good buy.
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