From a long-term standpoint, I still like the case for Micron (NASDAQ:MU) stock. Memory demand should rise over time, thanks to broader trends like IoT (Internet of Things) and 5G (fifth-generation) wireless. Falling earnings don’t make Micron stock look all that cheap right now, but estimates for mid-cycle earnings still suggest upside from a current price of $45.
That said, of late I’ve been much more cautious from a short-term perspective. Third quarter earnings in June helped catalyze the recent rally, but I was much less impressed by the report than the market seemed to be. The outlook given with September’s Q4 release underwhelmed, though Micron stock would get back most of its post-earnings losses.
To be sure, I’ve been far too cautious, as even with a recent pullback MU stock has gained nicely from its June lows. Going forward, however, I still see cause for concern. Recent trading in MU suggests investors are betting on a calendar 2020 recovery in pricing and a sharp rebound in earnings in fiscal 2020. Those expectations leave room for disappointment, and potentially a lower share price.
What the Cycle Means for Micron Stock
Micron might well be the most cyclical company in the world. Full-year adjusted earnings per share in fiscal 2016 (ending August) were just six cents. Two years later, non-GAAP EPS was nearly 200 times as high, at $11.95. Profits then fell by nearly half the following year, and Micron guided for first quarter 2020 EPS to decline over 80% year-over-year.
Cyclical stocks in general can be difficult to value, given the number of assumptions required. At what point have earnings peaked? When have they bottomed? What is the so-called ‘mid-cycle’ figure — an estimate of profitability between those two points?
These are all questions that investors can answer very differently, which explains why MU stock has seen some of the same volatility as its earnings, if obviously not to the same extent. It’s why Micron stock traded, at one point not that long ago, at less than four times earnings: the market recognized (correctly, as it turned out) that pricing and profits were headed for a steep fall. Of course, it’s also why an investor can logically argue that MU stock is cheap now, even though it trades at over 18x consensus estimates for fiscal 2020 EPS.
After all, 18x earnings is a steal if those earnings are coming at the bottom of the cycle, just as 4x is a dangerous multiple at the top. Right now, Wall Street at least believes the bottom is in sight. FY21 EPS estimates sit at $5.28 on average, albeit with a wide range: $3 to $8.75. That consensus estimate suggests profits will double. Unsurprisingly, the average target price near $55 implies 20% upside from the current MU stock price.
The gains in Micron stock so far suggest that investors are looking ahead to a better fiscal 2021. And that seems like the biggest risk at the moment.
Is the Bottom In?
What drives most of Micron’s earnings volatility is pricing. Industry-wide shortages and big demand led both DRAM (dynamic random access memory) and NAND (short for “not and”) pricing to soar. Micron earnings followed. Pricing on both fronts declined, and so did profits.
The long-term case for Micron’s unit demand is based on the broader tailwinds benefiting other semiconductor stocks and other tech names. Pricing, however, is a bit of a different story. That depends not just on demand, but on supply. Memory manufacturers (including Micron) too often have built capacity to capture high pricing, leading to oversupply, plunging prices, and falling profits.
This time, the industry (which is mostly Micron, Samsung, and SK Hynix on the DRAM side) swears it will be different. Micron already is lowering its capacity investments significantly in both NAND and DRAM in fiscal 2020, per the Q4 conference call. That should keep inventories low and pricing stable-to-positive, allowing fiscal 2021 earnings to bounce back after a trough year in FY20.
But rivals need to cooperate as well, and historically that hasn’t been the case. Going forward, China’s Changxin Memory is on track to become that country’s first legitimate DRAM producer, and that could add supply at an inopportune time.
Meanwhile, Micron itself still seems cautious. The company accelerated its cut in NAND capacity. Management noted that inventories remain somewhat high. The outlook on that side of the business likely drove some of the post-earnings weakness in Micron stock. And MU stock wasn’t the only name to stumble after earnings: NAND rival Western Digital (NASDAQ:WDC) saw its stock plunge late last month.
There’s some evidence to suggest that a bottom might take longer than bulls think at the moment. And that could be a near-term problem for Micron stock.
The Near- to Mid-Term Worry for MU Stock
In theory, cyclical stocks should see their trading somewhat smoothed by the market. At peak earnings, multiples come down. At the trough, those multiples expand.
In practice, it doesn’t work out that way. Investors get too optimistic near the top, which is what happened with Micron stock in the first half of 2018. They get too pessimistic at the bottom, as appears to have been the case both late last year and in May-June of 2019.
But usually, cyclical names start to make their move a few quarters before the underlying earnings trend shifts. That’s what happened to MU stock last spring. It’s what happened to Caterpillar (NYSE:CAT), a classic cyclical stock, at the top in 2012 and ahead of the bottom put in 2016.
In recent months, Micron stock has rallied, suggesting that investors are forecasting a recovery next calendar year. But of late, that optimism is cracking. MU stock’s technical picture doesn’t look all that bullish. That of WDC is even worse.
Meanwhile, memory names have rallied while the rest of the sector is soaring. Advanced Micro Devices (NASDAQ:AMD) and Nvidia (NASDAQ:NVDA) both have broken out while Micron stock has struggled. At least at the moment, the market seems bullish on the long-term catalysts for chip demand. But it doesn’t seem to believe those catalysts are making their way to memory prices any time soon.
On the Sidelines
Admittedly, that could be an opportunity, with MU and WDC joining the rally at some point. But from another perspective, it’s a problem. Again, pricing is key for memory stocks, Micron in particular. There’s just not much evidence from Micron itself or the market that pricing is coming back as quickly as the MU stock price suggests it will.
Simply put, that’s a problem. It doesn’t mean Micron stock is a short, or even a bad investment at $45. But it does mean that Micron stock could get cheaper, quickly, in the coming months, and that long-term investors at the least might consider waiting for a better entry point. The rally in Micron stock of late has come because many investors believe a rebound is imminent. If those investors are wrong, they may reconsider their thesis — which would lead to a wave of selling in Micron stock.
As of this writing, Vince Martin has no positions in any securities mentioned.
