Micron reported Q2 results that beat estimates and guided for Q3 sales and earnings growth above expectations. However, Micron’s share are off 9% post-earnings, which may be due to commentary around soft demand in China, slowing PC sales and concerns that Micron may be nearing the top of the cycle. We believe that these concerns are temporary, and that Micron is structurally becoming a less cyclical company, which deserves a premium multiple. I discuss the company’s latest results and why we believe the recent sell-off is overdone in more detail below.
Micron’s Q2 FY2022 Beat Expectations and Guidance Was Above Consensus
Micron reported Q2 FY2022 results on March 30th, and sales increased 1% QoQ to $7.8 billion driven by a 4% sequential rise in NAND sales, which accounted for ~25% of total revenues. NAND sales also increased 19% YoY and management expects NAND sales to increase by ~30% YoY for the year. Demand for NAND is being driven by Micron’s new 176-layer NAND technology, which represented the majority of Micron’s NAND shipments. We explained the importance of 176-layer NAND here, stating that Micron has significantly increased memory capacity and is a leader in this technology, allowing the company to capture more market share.
Importantly, the strength in NAND should also be a tailwind for Lam Research, which sells the etching equipment necessary to build the layers for 176-layer NAND. In our latest update on Lam Research, we explained that “the key reason we think Lam could fare better than its peers is because as 3D layers increase, capital intensity also increases. The process does not scale linearly, instead it’s non-linear because it takes longer than 2X to etch a stack that is 2X high and requires more complex etch and deposition equipment”. With Micron guiding for $12 billion in Capex this year and plans for $150 billion in capacity expansions over time, we should expect Lam Research to see strong demand for etching equipment going forward.
Micron’s NAND prices also benefitted from the contamination of ~8% of the global supply of NAND. In February, memory peer Western Digital disclosed that there was a contamination event at two of its Japanese JV facilities, which resulted in 6.5 exabytes of NAND memory being contaminated. Likely benefitting from this event, Micron’s Q2 NAND prices rose ~4% QoQ, driving much of the topline growth as volumes were flat. As shown below, Micron has outperformed relative to Western Digital YTD, however, both companies have underperformed the broader market in 2022. I outline a few reasons for this in more detail below, which we believe are only temporary.
Similar to NAND, DRAM sales increased 2% QoQ and were up 29% YoY to $6 billion, or 73% of total sales. DRAM volumes increased but were offset with a decline in ASPs. Strong demand in datacenter drove the increase in DRAM sales. For example, Micron’s largest segment, Compute and Networking, grew sales 31% YoY to $4 billion, driven by a 60% YoY rise in data center sales which were “supported by robust demand across our DRAM and SSD portfolio” (Q2 call, 03/30/22). DRAM sales benefitted from Micron’s leading 1-alpha technology which is increasingly being adopted in the memory-intensive cloud environment. During the Q2 call, CEO Sanjay Mehrotra stated that DRAM sales will continue to ramp into 2023 when he said that “We have broadened the qualifications for our 1-alpha DRAM products and are well positioned to support the data center DDR5 transition driven by new CPU platforms, which are targeted to begin ramping later this calendar year and gain momentum in 2023”.
Following the strength in cloud sales, Storage sales increased 38% YoY to $1 billion as SSDs continue to replace HDDs, while Embedded sales increased 37% YoY driven by strength in automotive. A blemish was weakness in Mobile sales, which increased just 4% YoY to $1.9 billion. While the rollout of 5G phones will lead to a ramp in memory content per phone, there may be demand headwinds on the horizon. For instance, Apple cut its forecast of 5G iPhone shipments by ~20%. I discuss this in more detail below.
Continuing down the income statement, gross margin increased by 2,100 bps YoY and 100 bps QoQ to 47%, benefitting from higher NAND margins and the ramp in 1-alpha DRAM and 176-layer NAND technologies, which reduces costs as it scales. Management noted on the Q2 call that most of the efficiency benefits have been realized, and that margin expansion from the ramp is largely behind the firm. Furthermore, YoY gross margin comps were impacted by a one-time $300 million charge taken last year when Micron switched to FIFO accounting.
The strength in gross margin flowed down to operating profit, which increased 118% YoY to $2.7 billion. The dramatic rise in profitability was driven by higher selling prices and cost reductions from the ramp in new technologies outlined above. However, Micron has historically been a cyclical industry, and there may be concerns that Micron is nearing the top of the cycle. This may explain the recent sell-off in Micron’s sales, yet we believe that Micron is becoming structurally less cyclical and that its multiple will rebound once this is clearly evident in future results (discussed in more detail below).
Finally, GAAP earnings per share were $2.00 while non-GAAP EPS was $2.14, which beat estimates by $0.16. Non-GAAP EPS increased 118% YoY and the strength in EPS growth should continue going forward. For instance, Micron will benefit from a lower tax as Idaho’s governor signed a new tax law on March 16th, 2022 that will reduce Micron’s taxable income (Micron is HQ in Idaho). The CHIPS act may also be a tailwind to earnings as the US government looks to incentivize reshoring of manufacturing capacity.
As of the end of the quarter, Micron had $12 billion in cash and equivalents and free cash flow was over $1 billion during the quarter. Management stated that they expect free cash flow generation will be “substantially higher” over the next two quarters relative to H1 2022. Micron intends to use ~50% of its free cash flow to buy back its stock and pay dividends to shareholders. Since 2019, Micron has reduced its share count by an aggregate 113 million, or by 9%. With Micron guiding for record sales and profits in FY2022, cashflow generation should be significant, which will support more buybacks in the future.
Looking forward, management expects Q3 sales to grow 18% YoY to $8.7 billion, which beat initial topline estimates by 6%. Management stated that they are “tracking ahead” of their initial guide set in Q1 for FY2022 and that demand remains strong, but noted during the Q2 call that “there are some pockets where semiconductor shortages have not improved as fast as we had expected, and these shortages are likely to continue into calendar year 2023”. Nonetheless, Q3 adjusted EPS is expected to grow 14% QoQ to $2.46, which beat initial estimates by 9%.
Potential Risks are only temporary
As discussed above, Micron reported strong top and bottom-line results, guided above consensus and expects to be report record sales and earnings in FY2022. However, despite this, Micron has underperformed in 2022 and is off ~9% since announcing FQ2 results. This may be due to a couple developments: 1) softness in mobile and PC sales and in China, 2) and concerns that Micron may be nearing the top of the cycle.
In regards to the first point, during the Q2 call management stated that “We see some weakness in the China market as the local economy slows, smartphone market share shifts and some customers take a more prudent approach to inventory management.” CEO Mehrotra added that he expects PC unit growth will be “flattish”. These comments may have contributed to a post-ER sell-off, and it is notable that AMD is also off following the Micron Q2 print, likely due to its exposure to PC sales. However, management added further color that enterprise PC sales are expected to be strong in the near term, which are more content rich in terms of DRAM and NAND content, which should offset this pressure.
Moreover, 5G phone sales are just now starting to ramp, but the timing of this ramp remains unknown. As mentioned above, Apple has reportedly cut its production forecasts for its first 5G phone by ~20%. While this may be a near-term headwind, it is inconsequential in the long term. This is because 5G phones will inevitably take share from 4G going forward, and 5G phone DRAM content is 50% higher than 4G, while NAND content is >100%. We expect mobile will be a tailwind going forward, despite the near term uncertainty in the pace of the ramp.
Finally, a trend that is typical with highly cyclical companies is that investors tend to reduce exposure when earnings are high due to concerns that the company may be nearing the top of the cycle. Historically, Micron has been a highly cyclical company with periods of oversupply and rapidly declining prices. However, with more demand drivers coming from data centers/cloud and automotive, memory demand is no longer dependent on the short-cycle PC market.
During the Q2 call, CEO Mehrotra explained that over 75% of its quarterly volume are under long-term agreements (LTA) that go out beyond four quarters or more, up from less than 25% in prior years. CEO Mehrotra added that all of the company’s large customers are now under LTAs, which helps improve demand visibility and reduces uncertainty. An increase in LTAs significantly reduces the cyclicality of Micron’s business.
Moreover, new trends on the horizon further smooth demand for memory, reducing Micron’s dependence on the short-cycle PC market. For example, CEO Mehrotra stated that “new EVs are becoming like data center on wheels, and we expect over 100 new EV models to launch worldwide in this calendar year alone”. The memory content in higher end EVs is 15x higher than the average car, which further reduces the cyclical nature of Micron’s business.
As shown below, Micron trades at a 9x PE multiple, which is below where it was trading in 2017 and well below its multiple in 2020 and 2021. We believe that the market remains in a “wait and see” mode until Micron can prove that it is less cyclical. If Micron can prove that it is less cyclical going forward, we should expect a re-rating of its multiple going forward. A trend that supports this is the reduction in finished goods, which declined QoQ despite the softness in China, PC and mobile. A build in finished goods inventory would signal that demand may be weakening, a trend we have yet to observe in the memory market.
