As Micron Technology (MU -0.57%) continues to slide, now down 46% year-to-date, value investors are licking their chops, pointing to the strong cash flow and cheap valuation metrics. But these investors are either failing to look ahead and incorporate the cyclical nature of the business in their analysis, or they are erroneously believing “this time is different.”
Why the Memory Industry is Like the Oil Industry
What do the DRAM and NAND memory makers have in common with oil producers? They both produce commodities. DRAM, the working memory for computers and mobile devices, is the largest business for MU, making up approximately two-thirds of their revenue. The other third of Micron’s business is NAND flash memory, the type of memory used in mobile devices as well as solid-state hard drives which are becoming popular in laptops and other computers.
Both of these types of memory require expensive equipment to produce and highly developed knowledge. But at the end of the day, they are still commodities and virtually identical to what the other big memory producers make. This means prices of DRAM and NAND are driven by industry supply and demand, and are therefore just as prone to cycles as oil prices.
Why the Cyclicality?
When demand is high, as we saw when demand for smartphones and tablets were exploding, and the industry is undersupplied, prices remain high, creating huge gross margins and high profitability for all of the players in the industry. But as prices remain high, the memory producers have an incentive to ramp up supply by running their fabrication plants at higher capacity or buying more equipment.
As supply ramps up or demand dampens, the industry becomes oversupplied and prices drop. Additionally, because of the rapid change in technology, inventory can’t be held for too long due to risk of obsolescence. It then becomes a race to sell as much product while the prices are still above cost. But eventually prices decline so much that gross margins shrink and it is not uncommon for operating margins to go severely negative as Micron experienced in 2008, 2009 and 2012.
Eventually capital expenditure on equipment is reduced and plants are run at lower capacities. This reduces supply and prices start to improve. The cycle then repeats.
Why Doesn’t the Industry Learn its Lesson?
The first reason is that future supply and demand is not known ahead of time. Memory producers must hazard a “best guess” as to what demand and prices will be in the future. For example, they are fairly certain demand will be higher, so they go ahead and order more equipment and build new fabrication plants. But they will not know if their judgement was correct until a year or more later, once the plant is complete. By then it is too late if it turns out they are wrong.
Second, there is the element of what economists call “game theory.” This is the study of how players make decisions based on what they believe their competitor will choose. Like other commodities, producers would all be better off if they restrained supply, keeping prices high. But if they did this, each producer would have the incentive to then increase their own supply to take advantage of the high prices. Once the suppliers recognize this, they realize they will only be losing market share if they don’t increase their supply as well. In the end, they all rationally choose to produce more than the optimal amount.
This Time is NOT Different
Bulls for Micron believe this time is different because the industry has been consolidated to three major players. But economics tells us that even with two or three players the incentives remain the same and it is unlikely the cycle will be eliminated. Others believe the shift to mobile DRAM or 3D NAND will help differentiate their products, but there is little evidence so far that this is the case.
It is therefore erroneous to be looking at Micron’s current cash flow and valuation metrics and judging the stock as “cheap” or a deep-value buy, because this is looking backwards at its recent and most profitable phase of the cycle. Yes, Micron is currently trading around a low 7 times price-to-cash flow, but at the bottom of its last cycle it got as low as 2 to 3 times price-to-cash flow.
So how should investors evaluate Micron? The key is to monitor the big picture cycle of the memory industry, just as an energy investor would monitor the price of oil. Unfortunately, the price of DRAM and NAND are not readily available like the price of oil is, usually requiring a subscription to a data service like Bloomberg or an industry specific source like DRAMeXchange.
However, individual and retail investors can usually garner the trend of memory prices from various news sites. For example, DigiTimes recently featured an article analyzing the latest moves in DRAM pricing. According to the article, DRAM prices are expected to continue to fall through the end of 2015. Notice the article also shows how the stock price of MU is highly correlated to memory prices.
In conclusion, it appears the memory industry is still completing a regular cycle and I expect Micron’s margins will contract in the next few quarters as memory prices continue to fall. Also, unlike many oil companies, Micron does not pay a dividend while you wait for the cycle to reverse. Because of this, it is best investors try to find other opportunities and stay away from Micron for the time.
