Micron's Persistence Of Memory

By Stephen D. Simpson, CFA | October 04, 2011 AAA

Like the famous Dali painting, Micron (NYSE:MU) shares are looking droopy and melted these days. While the company has made meaningful strides over the past decade in becoming a more efficient and less commodity-focused memory chip company, the reality is that it is still operating in a brutally cyclical market niche and this is a downward cycle. All of this sets up as a good news/bad news story for investors - Micron is a poor candidate for long-term buy-and-hold investors, but today's valuation could be appealing for value and turnaround investors.

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A Tough End to the Year
Although Micron disappointed vis-à-vis a lot of analysts' expectations, the reality is that this is widely expected to be a washout quarter and underperformance in that sort of environment is not quite so troubling.

Revenue was down about 14% from last year and flat with the fiscal third quarter. DRAM was quite weak (fueled by a major sequential price decline), and strength in NAND was just enough to make up the difference. Again, this was not a terribly surprising result - look at the PC sales being reported by companies like Hewlett-Packard (NYSE:HPQ) and Dell (Nasdaq:DELL), not to mention all-around consumer electronics sales for any company not named Apple (Nasdaq:AAPL).

Micron operates a business with powerful operating leverage, but that cuts both ways. With the poor revenue performance this quarter, gross margin deflated more than seven points from the third quarter and was basically cut in half relative to last year. Although the company did a good job of controlling its spending, that decline in gross margin was insurmountable and the company tipped over into an operating loss.

Overhangs Aplenty
It takes no particular effort or imagination to see the bad news in the Micron story. Micron has always been sandwiched between large Asian players like Samsung and Hynix (that are often brutally price-competitive on the lower ends) and innovators like Sandisk (Nasdaq:SNDK). Moreover, we are in the midst of a cyclical trough in semiconductors and many consumer electronics companies like Research In Motion (Nasdaq:RIMM) and Nokia (NYSE:NOK) are abjectly struggling to find sales.

Said differently, investors are spooked by value-added chip plays like Broadcom (Nasdaq:BRCM), Cavium (Nasdaq:CAVM) and OmniVision (Nasdaq:OVTI), so it's no great wonder that a more commoditized play is struggling even more.

Making matters worse, investors are waiting to hear the verdict and damages in the case Rambus (Nasdaq:RMBS) has brought against Micron. Whatever the merits of the Rambus case, the reality is that other players (Samsung and Infineon) have chosen to settle with Rambus and there seems to be an expectation that Micron is going to be found liable at least to some extent. The question, then, is how much of the potentially $14 billion in damages that Rambus wants will the company actually get (and how will it be split with co-defendant Hynix)? As Micron has about $10 billion in shareholder equity, this isn't a small issue.

The Bottom Line
Crippling Micron isn't going to get Rambus what it wants or needs (which is money), and neither will pushing the company into bankruptcy. Still, there is a real risk that Micron could be on the hook for quite a lot of money to be paid out over quite a long time. Micron will almost assuredly appeal an adverse verdict, but this is a large potential liability that is difficult for would-be investors to accurate discount and factor into their models.

Rambus risk included, though, this stock could appeal to the risk-tolerant value hounds. Fiscal 2011 was a tough year, but Micron managed to produce free cash flow and valuations are certainly undemanding. Things could certainly get worse from here, but the risk/reward suggests that investors should at least consider this idea for riskier portfolios. (For additional reading, take a look at A Primer On Investing In The Tech Industry.)

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