No Longer a Commodity: Why Hedge Funds Are Lining up to Buy Micron

Micron (NASDAQ: MU  ) is one of the world's largest manufacturers of memory used in personal computers and smartphones. The company's main products include NAND and DRAM. NAND, also known as Flash, started out in USB cards for the storage and transfer of files. Since the introduction of the iPod in 2001 it has moved from portable music players to notebooks and smartphones. For example, your iPhone 5s contains at least 8 GB of NAND used to store pictures, music, and applications. DRAM has traditionally been used in PCs to assist processors in performing functions. It is not used as a mode of storage, which is is performed in PCs by your hard drive. Think of DRAM as short-term memory and NAND as long-term memory.

Industry overview
Over the past decade, pricing power issues have plagued the memory space. Numerous competitors, long lead times to build new facilities, and high capital intensity (wafer fabrication facilities can cost upward of $2 billion and take three years to build) have created significant pricing volatility. This is most evident in Micron's historical gross margins, shown below.

Micron's stock price has historically been highly correlated to its gross margin, and investors have assigned low P/E multiples to the stock given the uncertainty of its earnings.

However, it's different this time...

Rising demand for DRAM in smartphones
Personal computers have been the primary end market for Micron's largest business segment, with sales of DRAM accounting for nearly 40% of its 2013 revenue. With the relative decline of the PC market, the company's DRAM business has undergone significant margin pressure, incurring operating losses as recently as 2012. Despite the problems caused by the global transition toward mobile computing, Micron and its DRAM business are actually poised to benefit from the same long-term trends.

When it comes to handsets, most investors immediately think about Micron's NAND memory products used for flash memory storage. Flash memory has been the traditional way Micron products have ended up in smartphones.

What has been overlooked, however, is the amount of DRAM that manufacturers are beginning to incorporate into smartphones. As smartphones become as powerful as notebooks, the need for RAM significantly increases. Samsung's recent Galaxy Note 3 had 3 gigabytes of RAM. While the PC end market has stagnated, the mobile phone space has suddenly become a tremendous end market opportunity for the flailing DRAM segment and will dwarf the PC market in the next few years.

Two billion handsets are sold each year worldwide, with total sales still increasing at over 30%. Half of all phones sold are smartphones with average memory capacity between 500 megabytes and 1 gigabyte of RAM. Non-smartphone handsets generally have 256 megabytes of RAM. The per-unit increases in memory and growth in total global units will lead handset DRAM demand to overtake the PC end market in the near future, delivering renewed growth in the memory market and the company's financials.

Estimates

2014

2016

PC units (desktop + notebook)

75.66 million

54.66 million

Average PC memory

3.66 gigabytes

4 gigabytes

Total PC memory

276.54 petabytes

218.65 petabytes

     

Non-smartphone units

250 million

0

Average non-smartphone memory

0.256 gigabytes

0.256 gigabytes

Total non-smartphone memory

64 petabytes

0

     

Smartphone units

287.55 million

537.55 million

Average smartphone memory

0.75 gigabytes

1.5 gigabytes

Total smartphone memory

215.67 petabytes

806.33 petabytes

Source: ValuePenguin estimates.

Industry consolidation has changed supply and pricing dynamics
Just five years ago, the DRAM industry had many more players including Samsung, SK Hynix, Micron, ProMOS, Elpida, Inotera, Rexchip, and Nanya. The competition led to years of gross margin volatility, with supply and pricing a constant issue. Based on this history, investors are skeptical that Micron can maintain gross margin stability.

One thing the cynics miss is how much the memory landscape has changed. Where there were previously eight competitors in the space, there are now effectively three. Acquisitions, exits, and collapses have left only Samsung, Hynix, and Micron, with each controlling roughly 30% of the total market. With more control over capacity and no single major player, supply growth has become more tempered and will remain under control.

To understand the impact of this transition we can look at another computer component: the hard drive. Market consolidation into three larger companies -- Seagate, Western Digital, and Toshiba -- has helped the industry sustain gross margins. Investors have rewarded these companies with higher p/e multiples.

Buybacks an addition to shareholder value
As further evidence of the maturity of the industry, Micron and its competitors have started to return cash to shareholders. In its recent analyst day, SanDisk, a maker of NAND memory, committed to returning 60%-80% of excess free cash flow to shareholders.

Management at Micron plans to buy back shares with excess cash over the next few years. The company has 1.1 billion fully diluted shares outstanding and will most likely exit 2015 with fewer than 900 million. The combination of earnings stability, P/E multiple expansion, and share buybacks will lead to a significant increase in Micron's stock price.

Micron 's business is perfectly aligned to profit from the global proliferation of smartphones and the inevitable improvements in handset specifications. As the handset market reaches an inflection point in memory needs, the company's core DRAM business segment should see renewed strength.

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