UBS recently initiated Micron (MU, Financial) with a price target of $35, at a 30% downside. The firm cited potential headwinds on the supply side that can affect the average selling price (ASP) of DRAM by the end of 2019.
UBS gave Micron a 3.5x EBITDA multiple, arguing that Micron has a history of low multiples and that the market will punish downward revisions. However, the firm also noted that Micron is well-positioned to weather the downturn, and will stay bottom-line positive during the memory slump. UBS forecasted the memory weakness to persist during 2018 to 2020.
Nomura and Mizuho see a different picture though. Romit Shah of Nomura maintains a buy rating with a $100 price target while discarding the capital expenditure fears. Mizuho is also not very concerned about the supply, as stable pricing is set to offset any weakness in supply.
What was UBS thinking?
The downturn is grossly unwarranted as the memory market is expected to follow a healthy path during the next five years. Micron is already trading at an earnings multiple close to the average multiple of the company during the memory cycle of 2014 to 2016. Moreover, a behavioral justification for a 3.5x Ebitda multiple is a poor one; Micron didn’t have a favorable multiple in the past due to investors’ fear of a downward cycle. The industry has evolved since then due to the proliferation of connected devices. In short, UBS’s price target is misplaced, rehashing the same memory fears that are not actually there. Let’s analyze the facts.
There is no disaster brewing in the memory market
The demand for DRAM and NAND is expected to stay strong going forward. IC Insights almost doubled its 2018 growth forecast. The DRAM market is set to witness 36% year-over-year growth during 2018, noted IC Insights in its latest IC Markets forecast. The growth forecast for NAND is also revised upwards to 17% (previously 10%).
Source: IC Insights
Moreover, the DRAM market is expected to reach about $100 billion by the end of 2018; NAND will touch $62 billion. See the chart below:
Source: IC Insights and Focus Equity
Increase in DRAM and NAND demand growth is plausible due to the proliferation of data and the need of storage and processing. Server and mobile industry continues to increase the need for storage and processing. “Worldwide spending for devices — PCs, tablets and mobile phones — is forecast to grow in 2018, reaching $706 billion, an increase of 6.6 percent from 2017,” noted Gartner in its 2018 IT spending report.
Due to increased demand of storage and processing, average selling price (ASP) is staying stable, rather growing, in the memory market. According to IC Insights, “The DRAM ASP will register a 36% jump in 2018 as compared to 2017, when the DRAM ASP surged by an amazing 81%. Moreover, the NAND flash ASP is forecast to increase 10% this year, after jumping by 45% in 2017.”
Gartner, an authoritative analyst house, also sees the memory market improving in 2018. Favorable market conditions are set to continue during 2018. The price increases in DRAM and NAND are raising the overall outlook of the semiconductor market, said Ben Lee, principal research analyst at Gartner in a note on semiconductor forecast of 2018.
Server market has an under supply of memory due to growth in the construction of data centers in North America, noted the DRAMeXchange. They also forecast a growing ASP, at least until the end of the first half of 2018. IHS is also forecasting double-digit growth for DRAM during 2018. They expect the DRAM market to grow about 17% during the year. Overall, it seems the memory market will remain healthy, at least in 2018.
Micron continues to capture growth but trades at a low-multiple
There is no point in selling stocks like Micron, which generate almost all of their revenue from DRAM and NAND. More than 95% of Micron’s revenue comes from DRAM and NAND products. The company registered an astonishing 64.2% growth in revenue during the first half of 2018; the company is set to close the year with 44% year-over-year revenue growth. Despite stellar growth, the company trades at a nominal multiple. Micron supports a price-sales ratio of 1.67 based on forward sales while the forward price-earnings ratio stands at 4, which doesn’t even seem believable. See the chart below:
The chart depicts the price-earnings of Micron based on trailing earnings. How on earth can a company trade around a multiple that low when its earnings are expected to grow 30% a year during the next five years? Well, as detailed in an earlier piece, investors are still holding on to the idea of a cyclical decline in demand.
Even if the industry enters a down-cycle during the next couple of years, a multiple in low-single digits isn’t justified for Micron. What’s interesting is that Micron’s forward price-earnings is around 8, based on the lowest earnings estimate for 2019. You should note that this earnings per share target assumes around 50% decline in Micron’s earnings in 2019 over 2018 earnings. Overall, the low valuation of Micron is supported by irrational fears of a catastrophic decline in the memory market, which are actually not there.
Final thoughts
You should buy in fear and sell in ecstasy, a wise investor once said. The recent sell-off in Micron creates a buying opportunity as the memory market will not replicate the woes of the past in the exact same manner. The stock is trading at a multiple of a company that could be nearing bankruptcy. In stark contrast, Micron is set to post double-digit growth in earnings going forward. It’s time to buy into fear.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
