Micron's Troubled Waters: Financial Struggles And The China Investigation

The Cyberspace Administration of China's recent cybersecurity investigation into US semiconductor firm Micron Technology (NASDAQ:MU) has sparked a captivating debate surrounding its motives and implications. On one hand, the probe appears to serve multiple purposes such as sending a warning signal to other countries and strategically targeting Micron for its lobbying efforts and closure of its Shanghai chip design center. On the other hand, Micron's financial struggles, weak Q2 earnings, and cautious Q3 guidance compound the complexity of the situation. Despite these challenges, a credible bull thesis maintains a positive outlook for Micron in 2024, anticipating a recovery driven by improved DRAM industry demand-supply balance, adoption of DDR5, and increasing demand for AI technology. This analysis delves into these topics.

China Investigation

Our analysis of the recent cybersecurity investigation launched by the Cyberspace Administration of China (CAC) into US semiconductor firm Micron Technology suggests that it serves multiple purposes, including sending a warning signal to other countries and targeting a company perceived to have a negative influence on China's technology industry.

Based on a cursory review of China's Cybersecurity Law, network products/services that could be subject to review include mass storage devices. With China accounting for ~11% of Micron's FY22 (Aug) revenue to companies headquartered in the country, it is important to note that China is a more meaningful production base for electronics, such as smartphones and PCs. Therefore, we can infer that Micron's revenue in China is likely to be meaningfully higher than 11%.

The decision to target Micron seems strategic, as the company had been lobbying for US sanctions against China and recently closed its chip design center in Shanghai. The investigation may also serve as a warning to countries like Japan, South Korea, and the Netherlands, which have joined the US-led Chip 4 Alliance or restricted exports of advanced chip-making machinery to China.

The impact of Micron's cybersecurity review could be significant for the global memory chip market, potentially benefiting the firm's competitors. The investigation, which could take at least 30 days or longer, depending on its complexity, may result in various penalties and restrictive measures if Micron's products are found to have cybersecurity issues. Fines, market access restrictions, or even a ban could be possible outcomes.

Q2 Earnings Shows Times Are Tough

Micron's China investigation came at a moment of weakness for the company as it recently reported its FY2Q (February) revenue of $3.69 billion, representing a 10% decline quarter-over-quarter (qoq) and a 53% decline year-over-year (yoy). This performance was in-line with our expectation but 1% below the Street's consensus (FactSet).

The DRAM revenue, which comprised 74% of the total revenue, was $2.7 billion, reflecting a 4% qoq and 52% yoy decrease. This was mainly driven by bit shipments increasing in the mid-teens percentage range qoq while average selling prices (ASPs) declined by around 20% qoq.

The NAND revenue accounted for 24% of total revenue, standing at $885 million, which was down 20% qoq and 55% yoy. The NAND bit shipments increased in the mid-single-digit to high-single-digit percentage range qoq, but ASPs were down in the mid-20s percentage range qoq.

The company reported non-GAAP EPS of -$1.91, significantly lower than the Street's estimate of -$0.67. Micron spent $2.16 billion in capital expenditures (capex), resulting in a free cash flow (FCF) of -$1.81 billion. The FY2Q-end inventory stood at $8.1 billion, down 3% qoq, with inventory days decreasing to 153 from 214 in the previous quarter, primarily due to the inventory write-down.

Micron's FY3Q (May) revenue guidance of $3.70 billion (with a +/- $200 million range) was in line with the Street's consensus. The non-GAAP EPS (ex. SBC) guidance of -$1.58 (with a +/- $0.07 range) is lower the Street's expectation of -$0.96.

Micron's lower-than-expected results and the cautious outlook underscore the ongoing challenges in the memory market. We believe the company will continue to face headwinds in the near term, including pricing pressures and inventory adjustments. However, Micron's efforts to cut down capex and optimize its inventory position may provide some support to its financial performance going forward.

Counter Argument

While we are skeptical of the stock due to its weak Q2 earnings, weak Q3 guidance and developing concerns in China, we acknowledge there is a credible bullish thesis for owning the stock.

Our bullish scenario on Micron Technology is underpinned by the possibility that the company is well-positioned for a strong performance in 2024, as DRAM industry demand-supply dynamics recover after last year's downward memory trend. MU's revenue may have hit its lowest point in 2Q23, and a gradual recovery may occur moving forward, with significant improvements towards the end of the year.

MU's strategic actions to bring DRAM industry demand-supply dynamics back into balance could have played a critical role. By reducing bit supply growth and trimming its FY2023 Capex plan by 40%, the company has accelerated the inventory correction process. These measures could facilitate a healthier DRAM market, in which MU generates 74% of its revenue.

Furthermore, Micron, with a 26.4% market share in the DRAM industry, could be poised to expand its DRAM solutions and product mixes, enabling it to capitalize on the market recovery. While MU's ASP for DRAM and NAND declined in the short term, their efforts to reduce shipments could positively impact demand-supply dynamics and propel growth in FY2024.

Moreover, bulls are optimistic about the adoption of MU's DDR5, which could increase in 2H23, further bolstering revenue even amid weaker spending. The company is also well-positioned to benefit from the AI boom, as AI servers require significantly more DRAM content and NAND than traditional servers. This factor, combined with the increasing demand for AI technology, could drive the next phase of growth for MU, enhancing chip sales to data centers.

Financial & Valuation Analysis

The Street expects fiscal year 2023, ending August, to be a tough year for the company, with consensus estimates predicting a significant decline in revenue. Revenue is expected to fall by almost half, to $15.4 billion in fiscal year 2023, down from $30.8 billion the previous fiscal year. Fiscal year 2024 is expected to recover to around $20.3 billion, suggesting a rebound in revenue growth.

However, we acknowledge that forecasting revenues for the next fiscal year remains challenging, given heightened uncertainty surrounding macroeconomic and geopolitical factors. Free cash flow is expected to be -$4.3 billion this year, down from a positive $3.1 billion last year. In fiscal year 2024, free cash flow is anticipated to recover to a positive $3.1 billion. Earnings per share (EPS) are expected to decline from $7.75 per share in fiscal year 2022 to -$4.92 this fiscal year. Consensus estimates project a rebound in EPS next fiscal year to a positive six cents.

Given the lack of profitability for the company, we cannot use a forward EPS metric. With a market cap of $66 billion, the company is trading at around 22x FY2024 free cash flow, which appears relatively cheap, considering this is the first recovery year if it materializes. However, we must emphasize that predicting the EPS or free cash flow of this company in a highly volatile environment is extremely difficult.

Conclusion

Despite facing headwinds such as weak Q2 earnings, cautious Q3 guidance, and the ongoing China investigation, Micron Technology has a glimmer of hope. The company is expected to experience a recovery in 2024, driven by an improved DRAM industry demand-supply balance, adoption of DDR5, and increased demand for AI technology. However, it is crucial to note that forecasting revenues and free cash flows for the next fiscal year remains a challenging endeavor, with uncertainties surrounding macroeconomic and geopolitical factors at play. Since we cannot forecast the company's financials with any degree of confidence (which we believe reflects the low quality of the business and its inherently volatile end markets), we will stay underweight the stock until we have more clarity.