A Chinese court has barred Micron (MU, Financial) from selling several DRAM and NAND products across mainland China in a patent infringement ruling last Tuesday, filed by United Microelectronics Corporation (UMC, Financial) – a Taiwan-based semiconductor foundry – back in January 2018.
"UMC is pleased with today's decision. UMC invests heavily in its intellectual property and aggressively pursues any company that infringes UMC's patents," said Jason Wang, co-president of UMC in a press release.
The Fuzhou Intermediate People's Court of China has levied preliminary injunction on Micron that prohibits the memory giant from selling 26 DRAM and NAND products, including certain solid-state hard drives (SSD) and USB sticks in China. The U.S.-based memory maker is not wary of the injection as 1% loss of revenue is anticipated, according to a press release.
"Micron is disappointed with the ruling by the Fuzhou Intermediate People's Court. We strongly believe that the patents are invalid and that Micron's products do not infringe the patents. The Fuzhou Court issued this preliminary ruling before allowing Micron an opportunity to present its defense," said the senior vice president of legal affairs in the press release.
Micron is maintaining its $8.0 billion to $8.4 billion revenue guidance for the fourth fiscal quarter of 2018. The market seems largely indifferent to the development as the stock is down just around 2% since the news broke last Tuesday.
Does the injunction increase China-related risks?
In short, yes. Although Micron is set to lose a mere 1% of its revenue based on the current injunction, the judgment reflects the extent of risks Micron is facing in China. Trade wars between the U.S. and China can further aggravate the situation, which can potentially lead to material loss of revenue for Micron in China.
It is worth mentioning that Fujian Jinhua Integrated Circuit Co. Ltd. has also filed patent infringement claims against Micron in the same court back in March 2018, alleging that Micron is infringing certain patents by selling Crucial – a memory brand of Micron – DDR4 DRAM modules in China. What’s interesting is that Micron foresaw a material impact on the business as a result of patent infringement decisions against the company. The company explicitly noted the following in the results of its third quarter.
"A determination that our products or manufacturing processes infringe the intellectual property rights of others or entering into a license agreement covering such intellectual property could result in significant liability and/or require us to make material changes to our products and/or manufacturing processes. Any of the foregoing could have a material adverse effect on our business, results of operations, or financial condition."
Moreover, the company also operates assembly, test and module-assembly facilities in China. Given the aggressive direction the Chinese government is taking, things might get ugly for Micron going forward. Any injunctions against its manufacturing operations in China will adversely affect the supply and increase the cost of manufacturing for Micron.
It is worth mentioning that Micron generated $10.39 billion of its total revenue from China during the fiscal year-ended 2017, making up 51% of the total revenue during the period.
The bottom line: Micron is materially exposed to China, and the current politics-driven trade war and China’s aggressive stance against U.S.-based technology companies make Micron a high-risk bet for now.
Despite risks, holding Micron might prove beneficial
Long-run risk-reward for Micron is skewed towards the upside. In the worst case scenario of Micron losing all its China-based business, the stock is priced for perfection. Assuming a 40% decline in earnings per share as a result of China barring Micron from selling in the mainland, the stock is priced at $54 using an economic value added (EVA) approach to valuation.
Note that a 50% decline in revenue might not translate into a 50% decline in earnings per share, as barring Micron will limit supply, leading to higher average selling price of DRAM and NAND. Moreover, margin in China is potentially lower than in North America and Europe. This means than earnings won’t decline 50% in case China bans Micron altogether from selling in China.
EVA Valuation, excluding revenue from China
| Projections | Â | Â | 2018 | 2019 | 2020 | 2021 | 2022 | Perpetuity |
| Â | Â | Notes | Â | Â | Â | Â | Â | Dollars in million |
| Net Income | Â | Â | 8143.2 | 6083.0 | 6265.5 | 6453.5 | 6647.1 | 6846.5 |
| Â | Cost of capital | r*capital invested | 1489.7 | 1976.3 | 2477.6 | 2993.8 | 3525.6 | 4073.3 |
| Adjusted Net Income | Â | Â | 6653.5 | 4106.7 | 3788.0 | 3459.7 | 3121.5 | 2773.2 |
| Discount factor | Â | Â | 1.0 | 0.9 | 0.9 | 0.8 | 0.7 | 9.2 |
| Economic Value Added | Â | Â | 6653.5 | 3802.5 | 3247.6 | 2746.4 | 2294.4 | 25479.6 |
| Â | Â | Â | Â | Â | Market value added | 44224 | ||
| Â | Â | Â | Â | Â | Invested Capital | 18621 | ||
| Â | Â | Â | Â | Â | Value of the equity | 62845 | ||
| Perpetual Growth in Residual Earnings | -1.3% | Â | Price Target | $54.2 | ||||
Focus Equity Estimates
The valuation sheet reveals that the stock is priced for perfection, even discounting revenue from China.
Final thoughts
There’s material upside if the China situation develops in favor of Micron going forward. On the other hand, a negative development will effectively lead to minimal downside in the long run. In the short run, the stock will most certainly face downward pressure in case China bars the Idaho-based memory company from operating in the country. All in all, the stock offers asymmetric reward-risk for long-term investors.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
