Memory chip maker Micron Technology (NYSE: MU) has seen its gross margins - and subsequently net earnings - deteriorate in the past year in the wake of a steep downturn in spot pricing for most classes of memory chips. As a result, long-term holders of Micron have been wearied by a stock that is down over 20% in the past 12 months, versus a 20% gain in both the Nasdaq and S&P 500 indexes.
But weakness hasn't been limited just to Micron. The entire memory chip business has been suffering in the wake of a Microsoft Vista launch that produced very little momentum within the PC industry. Both businesses and individuals have been slow in adopting Vista, which requires an extremely high amount of memory to run effectively.
Research firm Gartner states that worldwide PC shipments increased by nearly 10% in the first quarter of 2007, compared with 12.8% during the same period in 2006. So, by no means is the PC industry in a slump - but many of the component makers were preparing for a stronger push this year, which has led to higher inventory levels at Micron, as well as at competitors like Samsung and STMicroelectronics (NYSE: STM).
Spot prices for the increasingly-commoditized memory chips, have fallen 30% and more during the first quarter alone. However, in the past few weeks, price levels have firmed, and many analysts predict the trend to continue into the second half of the year.
Micron A Memory Powerhouse
Micron Technology's two reportable business segments are in memory and imaging. The Memory segment is composed mainly of the aforementioned memory chips as well as NAND flash memory. Flash memory is quickly becoming a real breakthrough technology, as its end markets continue to grow in number. Flash memory is used in a plethora of consumer and business products, from computers, cell phones and TVs to iPods, cameras and even automobiles.
The company's imaging segment primarily sells image sensors to cell-phone makers for use in the digital cameras that are increasingly found in today's new handsets. After a few quarters of tepid sales growth, promising comments from competitor OmniVision (Nasdaq: OVTI) point to an upturn in demand for Micron's image sensors.
Micron appears to be highly leveraged to pricing changes within the memory markets - they contribute over 80% of the company's revenue. This makes it vulnerable during periods of weak pricing, but it also outperforms during periods of strong demand and stable supply.
Micron has been able to "hedge its bets" by participating in several joint ventures (JV) with other semiconductor firms; the JV structure allows for some financial protection, as claims can only be made to the venture itself and not Micron. The most important JV to follow in the next few years will be IM Flash Technologies, LLC, a partnership with Intel (Nasdaq: INTC) created just over a year ago to produce flash memory chips. Micron owns 51% of the JV, and is expecting to allocate $2 billion in capital over the next three years to get the operation up and running at full production.
I personally feel that NAND flash is going to penetrate much further into the existing memory market, and it's this belief that attracts me to Micron's long-term prospects. Micron has proven itself adept in the past at controlling costs through increased production, and if it can translate this prowess to the flash market, it should be able to increase production while driving costs down even further.
Earnings Have Been a Wild Ride
For the company's fiscal third quarter (ending June 1), consensus estimates call for a loss of 20 cents per share, although the range of estimates stretches all the way from a loss of 43 cents to a point where the company will breakeven. The breadth of this range shows just how volatile earnings from the chip makers can really be.
Considering the recent volatility in earnings, I look to the revenue numbers to help assess the valuation of MU stock, which currently trades for 1.64-times trailing sales, compared with 1.76-times at STM and nearly three-times at flash-maker SanDisk (Nasdaq: SNDK).
Micron still derives the majority of revenue from memory products, but it is pushing aggressively to gain market share in the NAND flash market as well as diversify its overall product portfolio. This is highlighted by the fact that Micron's percentage of revenue coming from memory fell to 76% in 2006, down from 92% just two years earlier.
Balance Sheet Risks
I am keeping a close eye about the cash burn rate at Micron these days, as expenses are rising for both SG&A and Research & Development. SG&A costs were up sharply over the past six months compared to the same period a year ago; the company attributes the increase to higher headcount from acquisition of Lexar Media last year, and the ramping up of the IM Flash facilities. (To learn more, see Don't Get Burned By The Burn Rate.)
Micron recently announced its intention to raise up to $1.1 billion in convertible notes to investors, which, combined with some recent sale-leaseback proceeds, should give the company the cash it needs to push big into the flash market. However, will the demand be there? That's the key.
Only time will tell, but I do think that Micron has a good chance to be the lowest-cost provider, a trait that should allow it to maintain healthy gross margins in the upcoming quarters. While the adoption rate has been muted thus far, look for a slow-but-steady upgrade cycle over the next year to help drive demand for higher-capacity memory chips.
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