Shares of memory chip manufacturer Micron Technology (NASDAQ:MU) soared on Wednesday after the company beat estimates for its fiscal third quarter and provided an optimistic view of demand for the rest of the year. The rally doesn't make much sense, though, given the pricing problems Micron is still facing.

Elevated inventory and a challenging environment

The market ignored the fact that Micron's earnings guidance was terrible. The company expects adjusted earnings per share to be cut in half in the fourth quarter compared with the third quarter. Those weak earnings will be driven by continued price declines, a result of persistent oversupply. While inventory levels at customers are improving, Micron's own inventory levels have ballooned.

"Over the last few months, customer inventory improvements have progressed largely in line with our expectations in most end markets," said CEO Sanjay Mehrotra during the third-quarter earnings call. The company expects healthy year-over-year growth in DRAM bit demand in the second half, along with improvements in NAND bit demand.

But that excess inventory hasn't vanished -- it's shifted from consumer to producer. "Even as customer inventory levels of DRAM and NAND improve across most end markets, producer inventory levels are elevated," Mehrotra said. Micron had $4.9 billion on inventory on its balance sheet at the end of the third quarter, up 11.7% from the second quarter, and up 36.4% from the prior-year period. That's despite revenue being down 38.6% year over year.

A Micron facility.

Image source: Micron.

Bit demand needs to rise significant just for inventory to stop piling up. The company expects the inventory situation to look better by the end of the year, but it probably won't be back to normal, according to CFO David Zinsner, who said, "We think we'll be in a relatively good spot by the end of the calendar year, may not be at quote-unquote optimal levels, but certainly in a healthier place ... "

While the market focused on Micron's prediction of rising bit demand, the company's overall outlook actually got worse over the past three months. "Although previously announced [capital expenditure] cuts will start to impact industry supply in the second half of the calendar year, our assessment is that further cuts in capex and bit supply will be required to return the industry to a healthy supply-demand balance," Mehrotra said.

Micron is doubling its NAND wafer start reduction from 5% to 10%, and it's cutting its capital expenditure outlook for fiscal 2020. Micron had previously reduced its fiscal 2019 capex outlook from $10.5 billion to $9 billion. The company now expects fiscal 2020 capex to be "meaningfully lower than fiscal 2019."

Micron's capex cuts imply that fiscal 2020 will be another tough year for the memory markets, at least in the beginning. If Micron were confident that this downturn was almost over, it wouldn't be slashing capex for next year. Eventually, capex cuts will help end this period of oversupply. But it will likely be at least a few more quarters before that begins to happen.

While Micron will ship more bits in the second half of the calendar year, its margins are going to keep getting worse as long as prices continue to fall rapidly. The company expects an adjusted gross margin of 29% in the fiscal fourth quarter, down from 39.3% in the third quarter, despite the expected improvements in demand.

The bottom line: It still looks like the worst is yet to come for Micron.