Description

Micron Technology

Company Overview

Headquartered in Boise, Idaho, Micron Technology is a key designer and manufacturer of digital memory (DRAM - ~73% of revenues) and storage (NAND - ~27% of revenues) solutions for data centers, mobile devices, consumer products, automotive, industrial, and computer end markets.  The company’s principal operations are in Taiwan, Singapore, Japan, The United States, Malaysia, and China.  Taiwan, Singapore, and Japan account for most wafer fabrication while Micron’s Malaysian and Chinese operation focuses on assembly and testing.  Over the past 5 years, Micron has made great strides in its research and development to reduce the technology gap that existed between itself and its competitors by advancing its technical expertise, shortening its development time, lowering its cost structure, and improving its manufacturing capabilities.  Recently, many of these benefits were masked by the headwinds impacting both Micron and the digital memory/storage industry.  Cost challenges stemming from supply chain disruptions and China’s Covid-19 control measures have negatively impacted manufacturing, assembly, and testing, leading to inflationary pressures in Q3 and into Q4 of fiscal 2022.  Today, Micron leads the memory and storage market with its 1-alpha DRAM and 176-layer NAND, both of which have received several important product qualifications, representing the majority of the company’s sales mix.  Micron continues to work directly with end markets and industries to create customized products for the automotive, cloud, and data center markets which has reduced the company’s dependency on commoditized products while improving its margins.  By the end of 2022, Micron expects to start ramping production of its 1-beta DRAM and 232-layer NAND.

In addition to upgrading its operations, cost structure, and industry leadership, Micron has also worked hard to improve the strength of its balance sheet.  In 2017, the company had ~$5 billion of net debt.  Today, the company, through its cash flows, has created a balance sheet with $5 billion of net cash.  In nearly 3 years, Micron has generated over $10 billion of free cash flows with approximately 70% being returned to shareholders via share and convertible bond repurchases and dividends.  The roughly $7 billion of current and long-term debt is staggered with maturity dates between 2023 and 2030.

Industry

Historically, the memory and storage business was a terrible business to invest in.  It was characterized by boom/bust cycles and too many irrational players willing to sacrifice profits for market share which meant that there was no return on investment or capital.  Over time, competition and lack of profitability forced many memory and storage manufacturers to shut down or merged with a stronger partner.  Today, there are only three key global producers of DRAM and approximately five main manufacturers of NAND, each focusing on profitability vs. market share.  This is not to say that the memory and storage business is immune to market cycles but gone are the “gold rush” days of growth at any cost.  In addition, the overall addressable market for both DRAM and NAND has expanded with burgeoning end markets like Data Centers, Automotive, and Industrial demonstrating sustainable growth that is not tied to the volatile demand of consumer cycles.

In 2006, data analyst, Clive Humbly, coined the phrase “data is the new oil.”  Just as oil fueled the industrial revolution, data is the feedstock that is powering the ongoing technology evolution in artificial intelligence, machine learning, e-commerce, communications, autonomous driving systems, social media, and lies at the heart of nearly every industry.  However, for data to be useful it needs to be stored, distilled, and processed which is exactly the role of semiconductors.  The more data that is collected and processed the greater the demand for memory and storage and with an estimated 25 Zettabytes of data created globally per year, demand is not going away anytime soon.

Over the past year, the market witnessed firsthand just how dependent the global economy has become on semiconductors chips.  Automobile OEMs, fearing a huge drop-off in demand because of Covid, quickly canceled chip orders only to find that demand for their automobiles quickly recovered.  Even though semiconductor chips account for less than 1% of a new car’s average selling price, the electronic sensors, high-end driver-assisted technologies, and infotainment systems that rely on those semiconductors make up over 40% of the cost of the most popular and profitable car models.  In past earnings releases, the global automobile manufacturers warned investors that an ongoing chip shortage has slowed, stalled, or even stopped production, forcing automobile OEMs to “park” their inventory of new cars, disrupting sales, and leading to empty car lots.

Covid also had a meaningful impact on both DRAM and NAND demand.  Initially, working and learning from home brought forward the demand for PCs, laptops, tablets, and other consumer products.  Going digital also strained data centers, which required more servers as people turned to streaming videos, ordering online, and attending meetings via video conferencing during their time at home.  As the economy began to reopen, many of the global supply chains were disrupted leading to logistics and procurement issues.  Fearing that chip shortages would continue for the foreseeable future, several industries began to over-inventory chips, abandoning “just-in-time” inventory management for “just-in-case” which has led to the recent decline in demand from the PC, Mobile, and Consumer products manufacturers.

The ongoing transition to newer and more robust platforms (3D 176-layer NAND & 1-Alpha node DRAM) has provided the memory and storage chip industry with improved supply capacity under its current manufacturing footprint, ultimately pressuring ASPs.  Over the past three years, as most of the large platform conversions have already taken place, being able to add more bits per wafer has reached a saturation point.  With no major FAB build-outs planned in the near term by Samsung, SK Hynix, or Micron, constrained supply and flattening cost curves should lead to durable and upward sloping ASPs once the recent volatility surrounding chip supply subsides. 

It is estimated that the global DRAM and NAND market is currently around $161 billion with Mobile and PC making up 50% and Data Centers accounting for 31%.  By the end of the decade, the DRAM and NAND market is expected to double in size to $330 billion with Data Centers accounting for roughly 50% of the revenue.

Investment Thesis

Micron Technology, through its expertise in design, production, and manufacturing will continue to transition its business from the lower margin, “commodity” memory and storage chips used in the PC, Mobile, and consumer markets into the “complex,” high-end, higher-margin chips used in Data Centers, Automotive and Industrial markets.  In addition, the company will be able to leverage its expanding long-term customer agreements to help plan for future supply and as a hedge against price volatility.

Operation

In both DRAM and NAND, the complexity of the chip is based on the chip’s longevity, power consumption, capacity, bandwidth, failure rate, heat generation, and latency.  Each end market has one or two key chip components that are crucial to their industry.  For mobile devices, it is low power consumption and heat generation.  PCs are more focused on high bandwidth and capacity and are willing to accept higher power consumption and failure rates (bit error/hour/gigabyte) because they are often restarted.  Data Centers, especially those working with heavy workloads and data, have several boxes that need to be checked including longevity, high capacity, high bandwidth, and a low failure rate.  The more high-level components that need to be included in a chip’s design, the more complex the chip, the higher the price, and the greater the margin.  

The automotive industry is quickly becoming the end market needing the highest level of chip complexity.  Besides being able to operate in extreme temperatures, the industry requires chips with high capacity, high bandwidth, low latency, low failure rates, low power consumption (mostly for EVs), and longevity over 10 years to correlate with the average life of a vehicle.  Modern cars have become a mobile computer platform incorporating more than 100 million lines of code used to run the vehicle’s Advanced Driver Assistance System (ADAS), In-Vehicle Infotainment (IVI), multi-camera vision processing, and manage the engine and powertrain.  As higher-level autonomous functionality is added, the lines of code are expected to increase to over 300 million requiring greater amounts of data to be both collected and processed in real-time, which, in turn, will require even greater capacity, bandwidth, and lower latency.  At a nascent $4+ billion in revenue, the automotive industry is the smallest end market for DRAM and NAND but it is also growing the quickest.  Over the next 5 years, revenues from DRAM and NAND are expected to increase 5-fold to over $21 billion as EVs become more popular and more cars incorporate level 3 autonomous driving.  On average, EVs have 15x more memory than the average car being produced today.  Even with this massive growth, the Auto industry will remain one of the smallest end markets but its growth will have a meaningful impact on Micron.  It is estimated that Micron's market share of the Automotive industry is currently over 50%, generating roughly $2 billion or 7.5% of total revenues, mostly from DRAM.  An investor can reasonably expect that even as Micron’s market share will be diluted from increased competition and OEM diversification, it can still easily generate automotive revenues that are 3x today’s levels and have a meaningful impact on the company margins and profits.

Automotive is not the only industry segment expected to have meaningful growth over the next 5 years.  Data centers and industrials are also expected to see a CAGR in the mid to upper 20s on the DRAM segment of the business with DRAM growth slowing in consumer segments, PCs, and mobile.  Even though growth is slowing in the Smartphone market (market saturation and increased replacement cycles), the amount of DRAM/unit will increase because of the growth in 5G connectivity.  Micron expects that, over time, its revenue mix will shift from lower margin “commodity” products to enterprise segments (Data centers, Automotive, and Industrial) which are less cyclical, have higher margins, and grow substantially faster.  Currently, PCs, Mobile, and Consumer products account for 55% of revenues with Data Centers, Automotive, and Industrials making up the remainder.  Within 5 years, the company expects a reversal with PC, Mobile, and Consumer to account for 38% of revenue and 62% coming from the Data Centers, Automotive, and Industrial.

In its most recent earnings call, Micron announced that DRAM and NAND demand from consumer markets including PC and Mobile markets had weakened.  As discussed earlier, Covid caused demand to be pulled forward, OEM inventories to be overstocked due to fear of chip shortages and inflation, and the consumer has become more cautious.  China, which represents about 30% of Micron’s revenue, mostly on the consumer side, had a large decline during the quarter as the country has been in lockdown.  Part of this weakness was offset by cloud, hyperscale, networking, automotive and industrial end markets.  In the past, it would have taken 3-5 quarters of painful price cuts for the memory and storage to rebalance.  In the new DRAM and NAND business paradigm, Micron quickly announced it will cut expenses and reduce production to bring supply and demand into line.  Although it is unclear how many quarters it will take for supply and demand to find their balance, what is clear is that, in the past, Micron and its competitors would be unwilling to slow production in the fear they would lose market share.

Micron is currently experimenting with long-term pricing agreements (LTA) with some of its larger volume customers.  These agreements expand on the supply contracts in place, which currently only commit the customer to a specific volume, to include price as well.  The goal of the LTA is to provide the customer with guaranteed supply and transparent pricing based on regular manufacturing cost reductions and in return Micron can plan for future demand and margins.

Valuation

Investing in a capital-intensive business may seem counterintuitive, especially in today’s uncertain business environment.  The difference is that Micron rewards that investment with returns on invested capital in the mid to high teens, strong cash flows, and share repurchases.  As Micron continues to expand into enterprise end markets, it will be repurposing its established fabs and generating higher revenues and margins from its existing footprint.  But that is all in the long run.  Currently, the stock is trading around 7.5x FY ’22 (9 months of actual diluted earnings and Q4 guidance) ~$8.00 EPS after the company guided Q4 FY ’22 lower.  It is unclear what Micron’s revenues and earnings will be for the first half of FY ’23 but given its quick response to declining consumer demand, many expect the company to exit FY ’23 on a stronger footing.  The company’s robust balance sheet and improving revenue and margin mix will help to support the company in the short run.  In the long run, an investor can expect Micron’s revenues and margins to recover and its EPS to return to the high single digits as it approaches the $10 EPS.

Risks

• Company principal manufacturing is located in Taiwan.

• Supply chains have been strained, disrupting production and leading to inflated manufacturing costs.

• China represents ~30% of revenues.

• The industry remains cyclical and negatively impacted by consumer demand.

Summary

Micron does not appear excessively cheap given its recent short-term guidance, but it is inexpensive when an investor considers the potential growth, especially in end markets like Data Centers, Automotive, and Industrial.  Data production and collection have increased exponentially, and there is no indication that it will be slowing anytime soon.  As the number of sensors, security cameras, mobile devices, and the Internet of Things (IoT) continues to become more prolific, so too will the data produced which will need to be collected and processed.  Additionally, as new platforms develop around virtual and augmented reality and as more businesses integrate AI and ML, the need for memory and storage will continue to have a strong tailwind.

Micron is a capital-intensive business.  Given the technical expertise needed in design, production, and manufacturing, the tens of billions of capital required to build fabrication plants, and the years needed to receive product qualification, it is very unlikely that a new entrant will disrupt the digital memory and storage business.  In the past, its business model was characterized by volatile boom/bust cycles and low (if any) return on investment and capital.  Over the years, the digital memory and storage industry has consolidated with three key manufacturers of DRAM and five manufacturers of NAND.  Today, manufacturers of memory and storage are more disciplined and rational, focusing on profitability over market share while focusing on producing “complex” chips that carry higher revenues and margins.  Over the next 5 years, Micron Technologies expects that over 60% of its revenues will be generated from high growth, less seasonal, more price stable enterprise markets vs. the roughly 45% it currently receives today.

Catalyst

Continued growth from Data Centers, Automotive, Industrial, and a higher amount of DRAM in PCs, and mobile devices.