My coverage on Micron Technology (MU) has been lacking so far in 2020 as the year was and continues to be dominated by Covid-19. In fact, the last update dates back late December as I concluded that a recovery was priced into the shares at $55 at the time.
Shares have fallen by another $10 to $45 due to the impact of Covid-19; yet unlike many semiconductor plays, Micron has not been enjoying the same momentum in its operating business. I like the valuation here, yet am not chasing shares here yet, although I am inclined to buy a further dip.
Over the past decade, Micron has been riding the wave of increased demand for its products for all the obvious reasons and megatrends, which have been underlining the increase in demand. While its business is typically somewhat of a commodity business (certainly in the past) on a net basis, the company has seen significant growth given these tailwinds.
About a decade ago Micron was more or less a struggling business with sales around $8 billion, at times reporting break-even results or even losses in a very competitive industry. Shares traded at single-digits in terms of the share price until the year 2013 as green shoots were emerging.
What followed was a steady increase in sales and with that a boom in 2014/2015, which pushed sales up to $16 billion and operating profits moving from small profits or even losses to $3 billion that year, for margins equal to 20%. After sales corrected to $12 billion in 2016, accompanied by flattish operating results, sales boomed again to $30 billion in 2018 with operating profits of $15 billion surpassing the revenues reported just two years before! With profits comfortably trending above $11 per share in the peak year and shares never trading above the $60 mark, it was evident to investors that those numbers were not sustainable.
What followed has been a fierce correction with 2019 sales down $7 billion to $23.4 billion, as a similar decline in operating earnings was seen, with operating profits down to $7.4 billion. With the company now just having reported its 2020 results it is evident that full-year sales have fallen further, having dropped by $2.0 billion to $21.4 billion, with the sales declines being exaggerated on the bottom line as operating earnings fell from $7.4 billion to $3.0 billion, with earnings falling more than twice the decline in sales.
As a result, earnings fell by nearly 60% to $2.7 billion, equivalent to $2.37 per share. The company continues to operate with a net cash position of around $2.6 billion, equivalent to around $2 per share.
The Old Thesis
In December of last year, I thought that the valuation looked compelling after the company just reported earnings of around $5.50 per share, which looked attractive with shares trading at around $55 per share, as the company held net cash equal to $2 per share as well. The resulting 10 times earnings multiple did not look like a stretch, certainly after earnings have been cut in half already from record earnings of $11.51 per share in 2018.
At the time, I concluded that the low earnings multiples were not automatically creating appeal despite trading at just 10 times earnings, even after earnings had been cut in half already. This came as shares actually had risen 50% in the six months leading up to December 2019. Another concern was that the 2019 numbers were not representative as based on historical standards the company was still over earning, at least in my opinion.
I pegged the long-term sales run rate at $25 billion and operating margins at 20% as perhaps a reasonable average throughout the cycle, translating into sustainable yet volatile earnings power around $3.50 per share.
If that estimate was correct, shares traded around 15 times sustainable earnings power yet the assumption about the sustainable revenue rate and margin potential was of course highly debatable. Bears claim that Micron remains a long-term cyclical commodity play with fat profits at some point in time and losses in the bad years. Bulls believe that the long-term demand for Micron’s product (SSD, Data Centers, Mobile, PC) and more differentiation make that growth and margins will become more sustainable and higher in the long run. As it turned out, the 2020 results did come in quite a bit below the anticipated run rate.
Promising are sequential achievements in the fourth quarter of 2020 with sales up 25% on an annual basis to $6.06 billion, at a run rate close to $25 billion. Quarterly GAAP earnings of $0.87 per share on an annualized basis already come in at $3.50 per share, basically in line with my long-term average estimated earnings power, as operating margins recovered to 19%.
The problem is that the green shoots in this quarter are not expected to be lasting with first-quarter sales seen at $5.2 billion, marking quite a sequential setback. In fact, GAAP earnings are expected to fall from $0.87 per share to $0.39 per share on a sequential basis.
Shares of Micron have fallen from $55 in December to $46 at this moment, which means that operating assets now trade around $44 per share. Based on the run rate of the earnings reported in the fourth quarter, multiples compressed to 12 times earnings, yet this rises to 28 times earnings based on the first-quarter outlook in which earnings are set to be cut more than in half on a sequential basis. Furthermore, capital expenditures continue to surpass depreciation expenses with capital spending of $8.1 billion surpassing depreciation charges by $2.5 billion in 2019. This creates a drag of more than $2 per share in cash flow conversion, with capital spending set to increase another $1 billion this year.
The softer outlook for the current quarter has some lasting components. The company cites that the impact of Covid-19 on the economy is taking a toll on a range of industries. The second impact is that of shipments halted to Huawei since halfway September, with this customer making up 10% of sales. There is another factor which makes that the sequential outlook looks soft, and this is the fact that the first quarter of the fiscal year of 2021 comprises 13 weeks instead of 14 weeks in the fourth quarter.
Truth be told I am a bit in doubt here. While the general semiconductor business has seen a big boost even since the outbreak of the Covid-19 crisis, Micron has been lagging compared to some of its peers. Consequently, it seems that the commodity nature of the business is bigger than bulls might have thought. While the company briefly touched upon its average potential in the fourth quarter of 2020, the upcoming year might be looking a bit softer, yet at the same time, shares are down about 20% since I last looked at the business late in 2019.
Based on the average earnings power of around $3.50 per share, valuation multiples have compressed from 15 to 12 times, yet it seems that the fiscal year of 2021 might become a softer year, certainly on the front of free cash flow conversion. I like the fact that the shares have come down a bit and while shares look more compelling, and I would be willing to initiate small in the low-$40s, I lack conviction to buy shares in size here.
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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.