Memory chip manufacturer Micron Technology (NASDAQ:MU) reported a net loss in fiscal 2016, the result of slumping prices for its DRAM and NAND chips. This year, the company is on pace to produce record profits, with prices buoyed by strong demand. Micron stock has soared along with revenue and profits, up about 160% over the past year.
Trading for around $30 per share, Micron stock looks cheap. Analysts expect adjusted earnings of $4.71 per share in fiscal 2017 and $6.02 per share in fiscal 2018, putting the forward price-to-earnings ratio at just 5. Micron's latest quarter was a blowout, with revenue soaring 92% year over year and both the top and bottom lines beating out estimates. The company's fourth-quarter guidance calls for more of the same.
A perfect storm of strong demand, constrained supply, and falling costs have enabled Micron's incredible profits. During the latest quarter, DRAM bit sales grew 5%, average selling price grew 14%, and cost per bit fell 6%. The same story played out with NAND, with bit sales surging 17%, average selling price rising 3%, and cost per bit falling 12%.
The DRAM and NAND chips that go into PCs and mobile devices are commodities, and during times of strong demand, Micron makes a killing. But the flip side of the coin is that weak demand crushes prices and erases those hefty profits. I can't say anything about the timing of when the current cycle of explosive profits will end, but I can say with a high degree of certainty that it won't last forever.
Those pesky cycles
Throughout the decades that Micron has existed, the boom-and-bust nature of its business has persisted. The length of the cycles isn't always the same, and predicting when profits will turn to losses and vice versa has been mostly a guessing game. But the boom times have always eventually ended, and the busts that follow plant the seeds for the next boom. Here's how Micron's quarterly operating margin has evolved over the years:
What we're seeing today is nothing new. A period of losses last year has given way to a period of profits, the same thing that played out a few years ago, and a few years before that, and a few years before that. This is no different than other cyclical commodity industries, like shipping and mining. Periods of fat profits result in increased supply in an attempt to take advantage. This eventually leads to oversupply, pushing prices and profit margins down. Production can't easily be adjusted -- the memory chip business is capital intensive, and the lag between when capital is committed to new production and when that production comes on line is measured in years.
Valuing Micron based on peak earnings doesn't make much sense. A P/E ratio of 5 based on peak earnings doesn't say anything about how cheap or expensive the stock truly is, just as a sky-high or nonexistent P/E ratio during periods of slumping chip prices doesn't imply that the stock is overpriced. Micron's net income has averaged about $400 million over the past decade, well below its peak net income of $3 billion and well above its trough net loss of $1.9 billion.
The longer this current cycle of impressive profits continues, the more convinced investors will become that this time around is different. But it's probably not different. Samsung began production of NAND in a new facility this month, and DRAM production is expected to follow down the road. SK Hynix announced late last year that it was building a new production facility. And China's state-owned Tsinghua is pouring $30 billion into a memory chip factory. The current state of demand outstripping supply is certain to end at some point.
Until then, Micron will continue to produce some blockbuster numbers, and investors will be tempted to believe that this is the new normal. Unless the memory chip business has fundamentally changed, it isn't.