Memory chips are, for the most part, commodities. When you manufacture commodity products, how much you can charge is largely based on supply and demand. When demand outstrips supply, prices and profits for manufacturers go up.
That's the story of Micron (MU 2.80%) during much of the pandemic. Soaring sales of PCs and devices, persistent demand for server memory, and supply chain constraints put the memory chip industry into a state of undersupply. In the fiscal year ended Sept. 2, 2021, Micron produced net income of $5.86 billion on $27.71 billion of revenue.
Shares of Micron have tumbled more than 40% this year, partly because the stock market has taken a beating, and partly because the memory chip markets have reversed course. Memory chips are now in oversupply, and prices have been falling fast.
Micron stock is starting to look tantalizing cheap after this rout, but investors need to be careful. This downturn is shaping up to be the worst in many years.
Valuing Micron is tricky
Micron's revenue and profits can swing up and down dramatically depending on the state of the memory chip markets. Because of this, using a price-to-earnings ratio to justify an investment is a bad idea. During good times, Micron stock will look impossibly cheap according to this metric. During bad times, it will look depressingly expensive.
Since Micron is a capital-intensive manufacturer, looking at how the price-to-book (P/B) value ratio compares historically can give you a rough idea of whether the stock is cheap or expensive. This ratio is useless for many types of companies. A software company will trade at a very high P/B ratio because it doesn't have much in the way of physical assets. But for Micron, it's worth looking at.
Right now, the P/B ratio tells us that Micron stock is about as cheap as it was at the bottoms of previous downturns.
MU Price to Book Value data by YCharts
One problem with this is that severe downturns can do a number on a company's book value. Micron expects to burn through $1.5 billion of free cash flow in the first quarter of fiscal 2023 alone, and it expects the second quarter to be challenging as well as it copes with elevated inventory levels. Long story short, Micron's book value is likely to decline over the next few quarters.
This downturn could be brutal
Micron CEO Sanjay Mehrotra and CFO Mark Murphy used the word "unprecedented" seven times in the company's latest earnings call with analysts. The macroeconomic environment is unprecedented. The rapidity and sharpness of the downturn has been unprecedented. The scope of inventory adjustments by Micron's customers have been unprecedented.
Micron expects to generate just $4.25 billion of revenue in the first quarter, with a gross margin of 25% and adjusted earnings per share right around breakeven. Revenue will be down 45% year over year based on that guidance, and the gross margin will be nearly cut in half.
Micron is reducing utilization in its factories to adjust to weakening demand, but ending the downturn will require other manufacturers to do the same. Whether that happens or not remains to be seen. Reducing production means sacrificing market share and accepting a drop in cash flow that comes with lower unit volumes. If any of the big players decide to focus on market share, Micron's actions won't have much impact.
Forecasts for memory chip price declines for the rest of the year are rough. TrendForce expects NAND pricing to fall as much as 20% in the fourth quarter on a sequential basis, with wafers expected to drop as much as 25% in price. The DRAM market will fare a bit better, but not by much. TrendForce sees DRAM prices dropping by as much as 18% in the fourth quarter, with double-digit declines across all end markets.
Micron has a pile of cash totaling more than $9 billion that will help it weather this storm, but a long downturn will eat away at that safety net. Micron stock looks cheap, and it very well may be, but this is the biggest challenge the company has faced in a long time. Invest accordingly.
