Seth Klarman (Trades, Portfolio) is often compared to Warren Buffett (Trades, Portfolio) because of his track record of successfully identifying unpopular value stocks. For this reason, many investors follow the guru to get insights on unloved stocks that have the potential to deliver multi-bagger returns in the coming years.
According to the third-quarter 13-F filing of the Baupost Group LLC, the guru has entered new long positions in Pershing Square Tontine (PSTH, Financial) and Micron Technology (MU, Financial). The investment in Micron is currently valued at $245 million, which gives it a portfolio weighting of just over 2.6%.
Source: GuruFocus
The semiconductor industry is highly cyclical and investing in a leading chip company right before operating conditions improve could lead to very attractive returns. An evaluation of the prospects for the industry and Micron's valuation levels suggest both value and growth investors should follow Klarman's lead.
Focusing on the long-term outlook is key
Before moving on to discuss why Micron is well-positioned to grow in the future, it's important to determine the company's revenue drivers. For the 12 months ended Aug. 31 (fiscal 2020), the company generated the bulk of revenue from its computer and networking business segment. Below is a segmental breakdown of total revenue:
| Business segment | Revenue (USD millions) | Contribution to total revenue |
| Computer and networking | $9,184 | 42.8% |
| Mobile | $5,702 | 26.68% |
| Storage | $3,765 | 17.5% |
| Embedded | $2,759 | 12.9% |
| All other | $25 | 0.12% |
Source: Form 10-K
According to data from company filings, the contribution from the mobile segment has improved from 21.6% in 2018 to over 26% in 2020, which is a promising sign considering the expected growth of smartphone sales in 2021. Micron's dependence on the computer segment attracted criticism in the past as laptop and computer sales are not expected to grow meaningfully in the future. However, 2020 will go down in the history books as an exception as sales skyrocketed due to the growth of the stay-at-home economy.
Data from Statista indicates global smartphone shipments have been sluggish in the last two years. However, 2021 could turn out to be the year in which the trend reversal occurs. The outlook for 2020 looks gloomy as the industry was hit hard by many negative developments over the last few months. The global recession, collapse in consumer spending and decline in retail sales are a few reasons behind this pessimistic expectation for this year. In a research report published in June, Fitch Ratings wrote:
"We forecast 2020 global smartphone shipments to fall by 15%-17%, following a decline of 4% and 2% in 2018 and 2019, respectively based on data from International Data Corporation (IDC). Consumers, affected by a surge in unemployment rates and lower disposal income, are likely to delay discretionary spending, which will lead to a longer smartphone replacement cycle. 1Q20 smartphone shipments declined by 12% YoY, led by a 20% drop in China, which accounts for a quarter of the global shipments, according to IDC."
Apple, Inc. (AAPL, Financial) has already launched a 5G-enabled mobile device, and many other manufacturers are planning to rollout multiple devices with this facility, which could trigger a supercycle in device upgrades according to many analysts. IDC projects the smartphone industry to come back strongly in 2021, and continue to carry on this momentum through the end of 2024.
Source: IDC
Considering Micron's increasing exposure to the mobile memory and storage industry, the promising outlook for smartphone sales in the coming years paints an optimistic view of what the future holds for the company. According to industry experts, 5G-enabled devices use up to twice the DRAM and flash memory compared to other smartphones. This characteristic will accelerate memory sales at a faster clip than device sales, which is good news for Micron.
The demand for chips will likely improve as a result of many other macro developments as well. The growth of concepts such as the Internet of Things, the accelerating pace at which developing countries are rolling out digitization plans, and the growth of cloud computing are a few examples.
The worst might be over for Micron
Paul Meeks, the portfolio manager of the Wireless Fund, believes that the estimated earnings of 45 cents per share in the current quarter will mark the bottom of the cycle for Micron and other semiconductor stocks. Speaking with Barron's, Meeks said:
"Micron has insane operating leverage, for better or worse. They are still cyclical, still prone to big swings, but in this cycle, they stayed profitable at the low."
He's not the only fund manager betting on a strong performance from Micron. Co-manager of the Columbia Seligman Communications and Information Fund Shekhar Pramanick recently wrote in a research note to clients that the change in the company's revenue mix from a DRAM-oriented model to a server and mobile-oriented model will pay off handsomely in the coming years as the demand coming from these two business segments are expected to hit new highs in the future.
Valuation
Micron stock is not cheap. The stock is trading near 52-week highs and is up approximately 30% this year. This positive market performance has masked the decline in revenue over the last couple of years, and an investor might prematurely conclude that Micron is expensive just by looking at the anomaly between the financial and market performance. As of Nov. 17, Micron is trading at a forward price-earnings ratio of over 23, and the multiple has continued to expand in the last couple of months as the stock hit new highs. The rich valuation comes on the back of investor expectations for strong operating results in the next few years. The market, not so surprisingly, has reacted in advance staying true to its reputation for being a forward-looking estimate on company value.
For investors to realize double-digit returns, Micron stock need not trade at an even higher multiple. If the earnings multiple remains static and Micron generates higher net income, investors would naturally end up with very attractive capital gains.
Seth Klarman (Trades, Portfolio) has a reputation for investing in companies when there's an acceptable margin of safety from a valuation perspective, and the guru would have certainly incorporated the current rich multiples into his model before executing the investment decision. Micron has performed surprisingly well at the bottom of the cycle, and there's only one way the company is headed if industry conditions improve as expected in 2021.
Takeaway
Seth Klarman (Trades, Portfolio)'s recent investment in Micron might surprise value investors considering the elevated valuation levels at which the company is currently valued at. However, markets are supposed to be forward-looking, and investors seem to have factored in the expected recovery of the semiconductor industry. The improving macroeconomic outlook and the company's prudent investments to expand its manufacturing capacity are likely to become catalysts in helping Micron report stellar revenue and earnings growth in the next few years. Even if valuation multiples do not expand any further, the projected growth in earnings per share will drive the stock price higher.
Disclosure: The author does not own any stocks mentioned in this article.
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