|Shares Out. (in M):||1,160||P/E||0||0|
|Market Cap (in $M):||65,360||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
|Borrow Cost:||General Collateral|
Micron Technology Inc. (NASDAQ:MU) is a supplier of memory chips used primarily in PCs, smartphones, tablets, servers, and other electronic products. Micron currently trades for $56 / share, and we believe several catalysts are playing out in the memory space and with Micron specifically that will drive Micron stock under $30 / share within the next 3-6 months. If a trade war with China intensifies and China remains committed to building out its own semiconductor industry, we believe the stock could go meaningfully lower than that.
Because memory chips are a commodity, Micron and other industry participants have been exposed to numerous cyclical peaks and troughs over the years. As is common with most commodity products, excess supply and/or deteriorating demand have caused severe dislocations in pricing at times, with average selling prices for Micron’s primary DRAM product historically falling by as much as 30-50% within 3 months. This has caused Micron to experience negative gross margins in 4 of the past 15 years.
We have followed Micron closely through several of these cycles. From 2009-2014, DRAM (and NAND, Micron’s other major product line) providers experienced tremendous growth. Driven by increased demand from smartphones, tablets, and a PC refresh cycle, memory chip suppliers were able to drive more favorable economics from their customers, and Micron’s gross margins grew from -9% in 2009 to a then-record 34% in 2014. Micron’s stock price responded in kind, going up over 600% from $5 in late 2012 to over $35 at its peak in late 2014. In typical fashion, Wall Street research analysts attributed the performance to secular growth that would continue unabated.
However, we saw signs of the cycle turning, as we saw a hiccup in PC demand at the same time Samsung was announcing a more aggressive push into semiconductors. DRAM prices started to drift lower well before Micron’s stock did, and we were able to short Micron in early / mid-2015. Just as had happened in prior memory and other commodity cycles, competitors began to cut pricing more dramatically to maintain market share. By the time the market troughed in mid-2016, DRAM pricing was down 46% from its highs. Even worse for Micron, gross margins went from a high of 36% to a low of 17%, and its share price was down nearly 75% from peak to trough.
Fast forward to today, and the exuberance in Micron / DRAM is at an all-time high. DRAM prices went up 240% from their 2016 lows, and Micron gross margins just hit a new record of 61%. As a result, just like the last cycle, the stock price has appreciated 540% in a little over two years. Sell-side analysts have responded in kind, with 24 rating the stock as a “buy”, 8 rating it as a “hold”, and not a single analyst rating it as a “sell”. However, we believe there are several factors playing out that can cause this cycle to turn even more dramatically than prior ones.
Following such a precipitous rise in commodity memory prices, industry participants have been eager to increase capacity. As the chart below shows, the industry net reduced DRAM wafer capacity from 2010 through mid-2016, primarily as a result of two major memory downturns and consolidation in the industry. Then, following an inflection in DRAM prices, we saw a net increase in wafer capacity starting in mid-2016 for the first time in over 6 years. Because capacity takes time to build, the bulk of capacity adds will begin in the second half of 2018. In all, we expect DRAM wafer capacity growth of over 15% by the end of 2019, which will mark the largest increase in capacity since before the Great Recession in 2007/08. Our thesis is confirmed by the massive boom in capital spending amongst semiconductor companies and the performance of semiconductor equipment suppliers Applied Materials and Lam Research. Both companies have had a marked increase in revenue over the past 18 months as they have supplied the equipment to DRAM / NAND manufacturers ahead of this material capacity increase.
YoY DRAM industry wafer capacity change
It is important to note that the wafer capacity growth is in addition to the 15-20+% growth in Gb per wafer that DRAM producers are continuing to experience. Therefore, even assuming DRAM demand continues to grow at 20+%, we believe the industry will be materially oversupplied within the next 6 months.
DRAM industry – supply / demand balance
As you can see in the chart above, this will mark the 4th time in 11 years the DRAM industry will reach a point of oversupply. In the previous three periods, DRAM prices from peak to trough were down 87% (2007-2009), 66% (2010-2012), and 46% (2014-2016). We believe this supply dynamic alone could cause DRAM prices to fall by 50+% in the coming quarters.
DRAM consumers are pushing back against the rapid increase in DRAM prices over the past several years. In April 2018, attorneys at Hagens Berman filed a lawsuit in the US District Court for the Northern District of California against the three largest DRAM players, Samsung, Hynix, and Micron. The class action suit, filed on behalf of smartphone and PC consumers in the US, alleges that the three manufacturers colluded on limiting supply DRAM supply throughout 2016-2017 in order to drive prices up. Hagens Berman claims it has evidence that the parties met during conferences / forums twice in 2016 and twice again in 2017 to discuss their intentions. Soon after, DRAM prices increased across the industry on both occasions.
With supply increasing not only with the three largest DRAM providers, but also with competitors in China and elsewhere, we believe memory providers will want to distance themselves from any doubts of collusion and will operate as rational market participants. We are already beginning to see this, as the charts below show that DRAM pricing is down 20% from the highs hit in March (the month before the lawsuit was announced). On the NAND front, we see a similar trend, with Samsung announcing it expects pricing to be down “high single digits” in both the third and fourth quarters of 2018.
DRAM pricing for 4Gb 512Mx8 – 2133 / 2400MHz
However, importantly, we believe Micron is more than just playing the DRAM cycle (although we believe the cycle is hitting an inflection point, which has worked very well through the years). In addition to the typical drivers that have historically caused boom / bust cycles in the memory space, the industry is currently facing a new major headwind that we believe will exacerbate the cyclical downturn and could cause secular issues for the current memory producers. That headwind is China.
Without getting too much into the political dynamics of US-China relations, we believe it is fair to say that Chinese President Xi Jinping is focused on turning China into a global economic and technological superpower on par with the United States. This was the cornerstone behind his “Made in China 2025” campaign unveiled three years ago. Semiconductors in particular are a critical element of the plan, since they are China’s top import and are used to feed its large electronics manufacturing sector. In order to make itself more self-sufficient and less reliant on global trade partners, China is setting out to produce more semiconductors at home. To do this, it must a.) catch up technologically to the current market leaders, b.) invest capital to build its own semiconductor industry, and c.) thwart the current large semiconductor companies. Recently, and increasingly, China is doing all three.
One of the primary showcases of China’s intentions in the semiconductor market has been the litigation between Micron and United Microelectronics Corp (“UMC”), a technology partner of Fujian Jinhua Integrated Circuit (“JHICC”). In December 2017, Micron filed a civil lawsuit in the state of California, accusing UMC of secret infringement of intellectual property related to its DRAM chips. China has had a history of trying to steal the intellectual property of US technology companies in order to “catch up”, and it seemed like this was yet another example. However, in January 2018, UMC filed a patent infringement lawsuit against Micron in China. At that point, it became clear that this case could become a proxy for Chinese-US relations in both trade and especially in the semiconductor space.
Things then heated up on May 31, when Chinese antitrust regulators raided Micron’s Chinese offices in connection with a suspected DRAM price-fixing agreement between Micron and Samsung. This would seem like an easy accusation, since the companies are already being sued for the same reason in the US and were twice fined in 1999 and 2002 by US regulators for fixing the price of DRAM chips. It is also a topic of great importance for China, as the country is the largest consumer of DRAM and imported nearly $90 billion of chips in 2017. Therefore, the recent rise in prices was a direct transfer of wealth from China to foreign suppliers. If found guilty, Micron could face a fine of up to $8 billion under Chinese antitrust laws. A major fine seems increasingly likely in light of recent US-China trade negotiations. It could also serve as an opportunity for Micron to share some of its intellectual property either through investigations or in exchange for a reduced fine.
China took the biggest step yet on July 3, when a Chinese court issued a ruling to temporarily bar Micron from selling 26 DRAM and NAND-related products in mainland China, as a response to the patent infringement case with UMC, which resulted in JHICC quickly claiming victory against Micron. Shockingly, Micron stock was only down 5.5% on the day and is now (7 trading days later) higher than it was before the China ban, despite China accounting for 51% of Micron’s 2017 sales. We believe this is mainly due to the Company’s $10 billion share buyback it announced earlier in the year, which is keeping Micron stock artificially inflated, despite these deteriorating fundamentals.
Now that China is building the necessary intellectual property and openly attacking the industry leaders, it is working to build its own home-grown semiconductor industry. One Chinese chip industry executive told the Nikkei Asian Review “It's so unhealthy about the recent memory price hike, and it's so unfair that such important components are controlled by very few companies… The road could be bumpy, but we need to have our domestic memory chips for sure, and we wouldn't care at first whether we could make a profit or whether we cause a price crash in the market.” To us, this sounds markedly like the boom-and-bust pattern we saw in industries such as display panels, steel, petrochemicals, and solar cells, where China wanted to enter at any cost and destroyed industry economics (industry participants in those industries often went to negative gross margins, while Micron currently has 60% GMs).
China will grow its spending on semiconductor equipment by 40% this year and represent 20% of the global market, only second to that of South Korea. Its regional governments are offering generous subsidies to attract foreign and domestic chipmakers. In NAND, which represents 30% of Micron’s revenue, Yangtze Memory Technologies, an affiliate of state-owned semiconductor maker Tsinghua Unigroup, is becoming China's first mass-producer of 3-D NAND flash memory chips. Although it seemed extremely unlikely just two or three years ago, they are now expected to start running by the end of this year. According to Akira Minamikawa, principal analyst at IHS Markit, "Starting in 2020, Yangtze Memory will determine the balance of the NAND market… The price of a 256-gigabit NAND chip could tumble to around $2.40 in 2021 from $7 or so in 2017."
While we are confident the supply and Chinese competitive dynamics will ultimately pressure DRAM prices / margins and will likely result in a large fine to Micron, there are several risks to our thesis. A true resolution to US-Chinese tensions, along with the Chinese government choosing to continue to outsource its semiconductor needs, would obviously take a great strain off the Company. Also, until we begin to see lower DRAM prices flow through Micron’s financials, it will continue to screen as a very cheap company on both an earnings and free cash flow basis. Add in the large share buyback, and the short may not work until everybody is “blindsided” yet again as to the cyclicality and operating leverage of the industry. Finally, the other risks are that demand meaningfully surprises to the upside (although we have made fairly aggressive demand projections in our analysis) or that “this time it’s actually different”, meaning the industry has consolidated, finally seen the “light”, and will curb supply as to not allow prices to fall (which is tough to imagine given increased Chinese supply and after facing multiple collusion lawsuits).
Altogether, we believe the DRAM industry is at the peak of its biggest cycle yet. However, this time IS different, in that there is a structural headwind unlikely to abate given President Xi’s commitment to build a self-sustaining semiconductor industry. Purely pricing in the cyclical element could send DRAM prices down 50% and Micron gross margins down below 20%, which would drive Micron stock below $30 per share. However, if Micron has to pay a large fine, is permanently kicked out of China, and China continues to build out its DRAM industry, there isn’t a true floor on the stock and it could go meaningfully lower.