Micron: Risk/Reward Turns Highly Favorable Following A Kitchen Sink Quarter (NASDAQ:MU)

Micron (NASDAQ:MU) may not have had the best quarter this time around, but I continue to be bullish on the long-term investment case. In my view, the key metric remains the gross margin trend, which continues to make higher lows and higher highs amid the DRAM downturn. Also keeping me bullish is the current management bench, which has executed exceedingly well through the current cycle.

Longer term, the transition to high-value solutions also underpins the gross margin upside, and thus, I see this cycle as very different from prior DRAM downturns. I wouldn’t try to time the inevitable cycle turn, but if gross margins are not going lower, neither is MU. And if DRAM recovery signs persist, we should see things turn in 2021. With the cautious guide weighing on the stock, I view any near-term weakness as an opportunity to accumulate MU.

Strong 4Q Revenue Comes with Some DRAM Caveats

Micron’s 4Q20 report was strong on paper – sales of $6.1bn (+11% QoQ) were well above consensus on strength in DRAM (~72% of revenue), as cloud, PC, and gaming demand boosted the quarterly performance. But I do question the sustainability of DRAM growth, though, as there was likely some demand pull-forward from Huawei pulling in shipments ahead of the September ban, as well as a short-term COVID-19-driven, work from home boost.

Source: Company Filings

The DRAM strength wasn’t quite reflected in NAND sales (~25% of 4Q revenue), which fell 8% QoQ to $1.5bn, on a high-single-digit QoQ decline in ASPs, as well as flat shipment growth. On a YoY basis, NAND revenue was still ~27% higher in 4Q and ~14% higher for the fiscal year. All in, this also implies contribution from NOR/other revenue down significantly YoY, by my estimates.

Source: Company Filings, Author’s Est

Gross Margins Post Higher Highs Despite Transitory Headwinds

I also took a lot of positives from the non-GAAP gross margin trend, which continues to trend upward – the 34.9% gross margin represents ~170bps QoQ expansion (~430bps YoY). Not only is this the highest level since 3Q19, but it also supports the call for underlying gross margins to continue inflecting higher, given the higher high/higher low trend. Key drivers of the expansion include strong cost execution in DRAM, which benefited from the 1z ramp. Also notable was that the gross margin result came despite under-utilization charges from the Lehigh fab (~$135m or a ~220bps headwind in 4Q).

Source: Company Filings

Plus, there’s still some inventory to work through, as 4Q inventory came in at ~$5.6bn (+4% QoQ), with inventory days also up to ~135 days. Relative to the long-term target of 110 days, that implies ample of room for margin expansion depending on management execution. Per the 4Q call, most of this is down to elevated NAND inventory as the company transitions to replacement gate and higher raw material inventory amid increased supply chain uncertainty. Assuming this normalizes toward the back half of FY21, gross margins should benefit from a nice tailwind.

Source: Company Filings

But the Post-4Q Guide Calls for a Worrying Gross Margin Reset

The big disappointment was in Micron’s guide. On the revenue front, the ~$5.2bn +/- $200m guide for 1Q21 was arguably a positive, given it accounts for the Huawei ban and conservative pricing assumptions. While enterprise spending is weak, and there is an inventory overhang at “certain customers,” strength in PC, smartphones, and auto demand, as well as an upcoming console refresh cycle, offer some offset.

Normalizing for the 14-week quarter in 4Q, DRAM shipment growth is guided at flat QoQ, while NAND shipments are set to rise moderately QoQ. This compares to management’s expectations for industry DRAM bit demand growth in the mid-teens %, with NAND in the mid-20% range.

For FY21, management is working off the assumption that market demand gradually improves through 2021, as an economic recovery and growth drivers such as new CPU architectures, 5G demand, and gaming and automotive strength kick in. That seems fair, in my view, and the FY21 capex guide of ~$9bn is (rightly) more conservative than pre-COVID-19 numbers, reflecting the continued industry-wide supply discipline.

Source: Company Filings

But with the gross margin guide moving down to 27.5% +/- 1% (vs. consensus of ~33%), investors have every right to be disappointed. Per management, the reset is due to an unfavorable mix shift toward NAND, conservative pricing assumptions, and temporarily higher costs related to the ramp of the first-generation replacement gate node and yield learning on new DRAM products. Assuming the transitory cost-related headwinds reverse, though, I see gross margins returning closer toward ~30% coming out of the February quarter.

Source: Investor Presentation

Gross Margins are Still on a Long-Term Expansion Path Despite Transitory Headwinds

Diving deeper into the gross margin dynamics, I think there is reason for optimism for long-term investors. Yes, Micron will face gross margin headwinds in 1Q, and likely 2Q as well, given the temporarily higher costs related to the ramp of the first-gen replacement gate (RG) and yield learning on new graphics DRAM products (i.e., LPDDR5 and GDDR6x) amid a weaker pricing environment.

But the path is clear for gross margins to improve in 2H21 as industry pricing and Micron’s cost structure look set to improve. Assuming strong execution with regard to both yield improvements on 1z/graphics products for DRAM and the transition to 2nd-generation RG products in NAND, these headwinds could instead turn into secular tailwinds. With second-generation RG NAND set for volume production in FY21, expect more meaningful NAND cost reductions in 2H21 and into FY22, which should drive NAND gross margin expansion.

In addition, Micron continues to move a greater portion of its bits to higher-value-added applications such as managed NAND and enterprise SSDs, which should prove accretive to margins as well. Thus far, NAND high-value solutions already make up ~80% of quarterly NAND bits. Recall that the opportunity here is vast – as of 2019, the addressable market in mobile high-value solutions stood at ~$39bn, with an extensive growth runway ahead.

Source: MBU Investor Presentation

Huawei Exposure to Zero Out Beyond September

I also think it is positive that MU finally bit the bullet on its Huawei exposure – the company will stop shipping to Huawei on Sept 14th, which implies Huawei’s contribution will zero out (from ~10% of 4Q Rev). Given the massive impact on 1Q revenue, the ~1% YoY growth still implied by the updated guide is impressive. Expect the impact to flow through to 2Q as well – but while it will take some time to rebalance toward other customers in mobile, the impact should eventually be offset. My base case remains for any Huawei headwinds to fade post-2Q21.

Though there was a small probability that Micron Commerce Department licenses would persist beyond the deadline (Sept 15th), I like that the company has decided to operate under the assumption that they will not. Thus, the current guide embeds zero exposure beyond the first two weeks of the November quarter, though there remains a non-zero possibility that MU is granted a license and revenue returns.

A More Disciplined Memory Cycle Drives Ample Downside Protection

Micron expects FY21 capex to come in at ~$9bn (vs. ~$8.2bn in FY20 and lower than the prior guide), with most of the capex increase in NAND. DRAM capex, on the other hand, is expected to be flat YoY in FY21. Most of the DRAM capex will be allocated toward new tool purchases primarily for technology transitions to improve cost structures. And with similarly disciplined capex dynamics across the other memory producers with regard to DRAM and NAND equipment, I am upbeat on supply/demand dynamics in FY21.

Micron exits 4Q with ~$9.3bn of cash and ~$11.8bn of total liquidity, which leaves it with ample optionality on capital deployment. The company repurchased $41m shares during the quarter, with free cash flow higher at $111m. The balance sheet is another key reason to be bullish, in my view – given Micron has typically had a weaker balance sheet in a cyclical trough (~$8bn in net debt at the 2017 cycle trough), investors gain a fair bit of downside protection this time around.

Source: Company Filings

Pressing the Reset Button

Calling cyclical bottoms can be messy, but at some point, I believe the challenges weighing on Micron’s margin profile will turn positive. And if industry dynamics are anything to go by, this cycle certainly looks very different – Micron and its competitors have remained disciplined in adding supply, and thus, the supply/demand dynamics look well-balanced. Plus, the company remains profitable even through a cycle downturn, and that type of resilience makes the path to a re-rating into the next upturn a lot more convincing, in my view.

The stock has underperformed amid several rounds of estimate cuts and continues to lag SOX despite improved long-term industry fundamentals. Thus, I view the recent dip following the 4Q reset as an opportunity to accumulate MU. I am basing this off a target ~1.6x book multiple on fwd book (vs the current ~1.3-1.4x), in anticipation of a cyclical recovery. Downside risks include pricing pressure in DRAM and NAND, as well as execution issues/delays in planned tech transitions.

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.

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