Micron (MU) managed to squeeze out some of the doubters last week by announcing a massive $10 billion share repurchase program, alongside some promising corporate updates. Already great profit momentum is only getting hotter, pushing up earnings yield towards 20%. Hence these earnings have attracted even more investors, following comments about the upbeat demand dynamics of the industry as well as strong cash flow return targets.
Reality is that Micron looks very cheap, even based on my guesstimate of “average” sales and margins across the cycle, at a time when the underlying business grows rapidly and cyclicality is rapidly coming down.
Micron delivered a good news for investors in recent days on a broad range of fronts. For starters, the company announced a massive $10 billion share repurchase program. This decision follows the new strategy of returning at least 50% of free cash flows to investors, with this strategy going into effect in the fiscal year of 2019.
While investors certainly appreciate such actions, there was more good news. Micron and Intel (NASDAQ:INTC) combined announced that they have delivered the first commercial 1Tb – 4bits/cell die, being very important for the development of the datacenter and client storage business.
Alongside all this good news, the company upped the guidance for the third quarter as well. Revenues are now seen at $7.7 to $7.8 billion, comfortably above the previous guidance which called for $7.2-7.6 billion in revenues. The stronger sales should allow earnings to come in at $3.12-3.16 per share, again ahead of the previous guidance calling for earnings of $2.76-2.90 per share. Following the good news, shares have risen from $53 to $61 in the time frame of just a week, being a strong run of course.
Great Earnings Yield Remains
Based on the guidance for the current third quarter, Micron is earning more than $12 per share each year at the moment, for an earnings yield of close to 20%, even after the run seen this past week. These earnings translate into great cash inflows for the business which Micron can use to finance these share repurchase programs, making that the party remains very good for investors.
At the end of the second quarter, Micron held $8.6 billion in cash, equivalents and marketable securities, offset by $9.3 billion in debt, for a net debt load of just $0.7 billion. With earnings power of $15 billion a year at this moment, this net debt load is very modest, allowing for massive share repurchases, even if we take into account that capital expenditures are surpassing depreciation charges to the tune of $4 billion a year at the moment. Even if we account for that, we have a free cash flow of close to $11 billion, equivalent to roughly $10 per share, as this results in a cash flow multiple of just 6 times at the moment.
Growing More Comfortable With Structural Earnings Power
One thing is very clear. Micron is benefiting greatly from acceleration of trends such as artificial intelligence and machine learning, yet current margins do not seem sustainable in the long run, even if rosy demand projections become reality. Note that examples of these trends which fuel the growing sales of Micron do not even include yet trends in autonomous cars, datacenter and Internet of Things.
Sheer reality is that GAAP operating margins of close to 50% seem like a stretch for a business which was traditionally very cyclical as cyclicality even resulted in sizeable operating losses in the past.
While the long-term outlook for sales remains very good based on many technological trends and developments, I question what the new range is for operating margins given that the business is still somewhat cyclical, but probably less cyclical as it has been in the past. Note only does the cyclicality stem from the demand side, which has become structurally more positive and more diverse, the supply side is helping as well. Traditionally, investments into NAND and DRAM involved multi-billion plants which resulted in high fixed costs and thereby large operating leverage. That said, consolidation and ever evolving technological capabilities make that competition from the supply side seems less fierce than it has been in the past, being helpful for margins as well.
Becoming More Optimistic
I have seen many instances appear in which a company trades at a low earnings multiple, making it a blind buy, only to see those earnings come under pressure. The simple reality is that a lot of things have improved for Micron from both the supply and demand side, probably reducing volatility of margins and increasing the average margins at the same time as well.
In October of last year I wondered how things have changed for the company in an article named: “Its different this time?” Reduction of the cyclicality of the underlying business and gradual improvement of the financial position made that both sets of risks, or perception of these risks, were no longer weighing on the stock to the same degree as they have done in the past.
In October of last year I noted that average gross margins barely hit the 20% mark over the past decade, as actual operating margins are now already coming in at 2.5 times the average gross margins reported in the decade before!
I furthermore guessed that the new normal average for operating margins could come in around 20% on sales of $20 billion, for a $4 billion operating profit number and $2.50 per share in normalised earnings power. As current quarterly earnings already surpass this number, it is evident that this has been a too conservative long-term estimate. One thing is very clear, operating margins of 50% will undoubtedly invite more competition, even as barriers to entry have been raised significantly.
Continuing to believe that current good times cannot last forever from a margin point of view, while sales could continue to grow in the long haul, makes that I am raising my estimates to $25 billion in annual sales and operating margins of 25% as an average for the cycle. I fully recognise that this is far less than current operating performance. Such estimated performance allows for sustainable profitability of close to $5 billion or $4.40 per share. Trading at $61 per share, this translates into a very compelling 14 times multiple, as the business is on the verge of achieving a flattish net cash position.
Given the continued more positive view which I have on the business, I have bought a small long position last week, as I am simply too much attracted to great earnings power, and long-term sales outlook. The upwards revised earnings power makes that I am comfortable holding a modest position, while cyclicality prevents me from chasing the stock higher after it has seen a great run already.
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Disclosure: I am/we are long MU.
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.