When it comes to memory chipmaker Micron (NASDAQ:MU), it’s all about the music. When the music is playing — supply in the memory market is falling and demand is rising — Micron’s numbers are good and MU stock heads higher. On the flip side, when the music isn’t playing — supply in the memory market is rising and demand is falling — Micron’s numbers are bad and MU stock heads lower.

Micron is set to report first-quarter earnings after the bell on Tuesday, Dec. 18. Obviously, investors will be listening for the music. If the music is playing, MU stock will spike after the earnings report. If it’s not, the stock could fall off a cliff.

How will investors know if the music is playing or not? There are many things you could look at. But, there’s one line item that carries more weight than all the rest: gross margins.

Gross margins are indicative of how high (or low) prices are in the company’s DRAM and NAND markets. When the music is playing, prices go up, and gross margins trend higher. When the music isn’t playing, prices go lower, and gross margins drop.

For the past several quarters, gross margins have been on a solid upward trend. This quarter, they are expected to fall quarter-over-quarter for the first time in a long time. Is this a trade war anomaly? Or is this the new norm? The answer to that question will determine where MU stock ends up after its Q1 earnings report.

Micron Stock: Gross Margins Are the Big Story Here

Things are going well for MU when supply in its core DRAM and NAND markets is limited, and demand is burgeoning. In that type of low-supply, high-demand market, NAND and DRAM prices rise, Micron’s gross margins surge higher and profits get really big, really fast.

That is exactly what has happened with Micron stock over the past several quarters. The memory markets were swamped with new and rapidly rising demand from next-gen tech end markets. But, these new technologies required more complex chips, the likes of which hadn’t been built in bulk yet. Thus, you had limited supply amid burgeoning demand. Gross margins soared to record highs. Profits hit record levels.

But, the pace of this growth has been slowing. From 3Q17 to 3Q18, Micron had developed a cadence of growing gross margins by roughly 200 to 400 basis points quarter-over-quarter. But, in 4Q18, gross margins only expanded 50 basis points quarter-over-quarter. Moreover, the guide for 1Q19 called for gross margins of 58.5%, which represents nearly 300 basis points of compression.

This slowing gross margin expansion trend that is suddenly turning into a compression trend is why MU stock has been so weak lately.

Investors will be watching the Q1 report closely to see if this compression trend is expected to persist or not. If gross margins do come in around 58.5%, and the guide calls for further compression in Q2, you could get a pretty big selloff in MU stock. But, if gross margins come in above 60%, and the guide calls for stabilization and/or improvement in Q2, you could get a pretty big post-earnings rally.

Thus, for Micon stock and its Q1 report, it all comes down to gross margins.

The Outlook Isn’t Great

Heading into the print, the outlook isn’t great for gross margins or MU stock.

Gross margins are being dragged down by two things. The first and smaller component is tariffs, which account for about 75 basis points of the projected 300 basis points of compression in the first quarter. The other 225 basis points of compression is from falling chip prices, which is the result of rising supply and falling demand in the company’s core memory markets.

The ninety-day trade truce between the U.S. and China gives MU bulls something to hang their hat on. But, nothing has really been accomplished during this truce on the chip tariff front. And, 2019 still lacks visibility with regard to how the trade war will play out. As such, trade war headwinds are still here, and Micron management will likely continue to bake those headwinds into its Q2 guide.

More importantly, the supply/demand dynamics throughout the semiconductor industry aren’t exceptionally favorable right now. End market demand drivers remain strong. But, the company is working through some inventory adjustment issues in the near term. In this short-term focused market, that’s a bad combo. Just ask Nvidia (NASDAQ:NVDA), which lost about half of its value on near-term inventory issues.

Overall, the outlook for a strong Q2 gross margin guide isn’t great. But, MU stock is already priced with this pessimism at just 3.5X forward earnings. Thus, if the guide does buck the market consensus and come in better than expected for Q2, you could get a big pop in MU stock.

Bottom Line on MU Stock

When it comes to Micron’s first-quarter earnings report, it’s all about gross margins. In order for this stock to rally, you need the guide to include gross margin stabilization and/or expansion next quarter. If you don’t get that, MU stock is liable to fall even further.

As of this writing, Luke Lango was long NVDA.