Santa rewarded Micron Technology (NASDAQ:MU) stockholders richly in 2016, delivering 40% share price growth in a year when the S&P 500 as a whole grew only 11%. And according to one banker, the gift-giving will extend into 2017.
Although initially skeptical of Micron's success, this morning, analysts at Needham & Co. announced they are abandoning their earlier underperform rating on the stock. Responding to last night's report of strong profits in fiscal Q1 2017, Needham is now clambering aboard the Micron train -- upgrading to buy and assigning a $33 price target.
If Needham is right, Micron stock promises to return another 40%-plus in 2017, just as it did in 2016. But is Needham right? Here are three things you need to know.
1. An upgrade for a reason
Micron reported its fiscal Q1 2017 numbers last night, and they were every bit as good as you might have hoped. Revenue shot 19% higher year over year (to $4 billion). True, profits were only $0.16 per share -- down 16% year over year -- but they reversed a three-quarter-long string of sequential losses at Micron.
These results significantly exceeded analyst expectations, with revenue about $20 million more than expected and profits $0.04 per share ahead of expectations -- good enough, apparently, to convince Needham to turn its sell rating into a buy.
2. All's well that begins well
As already alluded to, Micron's results not only exceeded expectations; they also broke a string of really unimpressive quarters at the company. According to data from S&P Global Market Intelligence, Micron lost money in each of the last three quarters of fiscal 2016, and ended the year with a $276 million loss. Revenue was also down sequentially in each of the past four quarters.
Luckily, 2017 appears to be off to a better start, with revenue finally rising again. Needham believes this is a trend that will continue, and for good reason. As the analyst explains in a write-up on StreetInsider.com today, "MU has regained its customer positioning in 20nm, is successfully migrating to 3D NAND (2nd gen 64-layer) and is benefiting from a substantially better pricing environment in DRAM." All of which points to a better pricing environment for computer memory -- and better profits for Micron -- in the year ahead.
3. Where's the cash?
One thing that has not improved at Micron, unfortunately -- at least not yet -- is the company's ability to generate cash from its business. Last year saw Micron burn cash in each of its final three quarters, right along with the GAAP losses the company was reporting. In Q1, Micron finally reported a return to GAAP profitability -- but as revealed by its cash flow statement, free cash flow remains firmly stuck in the negative.
Despite generating $1.1 billion in cash from operations in Q1 2017, Micron spent $1.3 billion on capex. This resulted in negative free cash flow of $150 million -- a stark contrast to the $130 million in positive free cash flow generated in Q1 2016.
Bonus thing: Can Micron get itself the rest of the way on track?
So how will Micron finally fix its business and begin generating cash profits to back up the accounting profits it's already claiming to be earning?
According to Needham, worldwide DRAM demand will grow between 20% and 25% this year, but supply of this flavor of computer memory will grow only 15% to 20%. This suggests the possibility of demand-supply balance in the industry -- but the likelihood that demand will outstrip supply, pushing DRAM prices (and Micron profits) up. Additionally, Needham sees NAND memory demand growing even faster -- as much as 40% to 45% this year. With such "huge" demand for both types of solid state memory over coming quarters, Needham believes Micron will soon be earning gross margins of "~36%" -- and will end the year with $3.30 per share in earnings.
If Needham is right about this, then Micron stock now priced at $23 and change is selling for just seven times this year's profits. That's a level of profitability that Micron hasn't come close to matching in any year this century. The closest it came, really, was 2014, when per-share profits hit $2.87 per share. But that year, free cash flow at the company approached $2.6 billion. Assuming profits 15% higher than that year imply similarly better free cash flow, the stock could generate as much as $3 billion in cash profits this year, and be trading for just 8.7 times free cash flow. Any way you look at it, these are attractive numbers, and an attractive argument for buying the stock if Needham is right about the demand.
We'll see how that works out the next time Santa swings his sleigh around, in December 2017.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he currently ranks No. 346 out of more than 75,000 rated members.
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