Many were shocked when they heard the guidance for FQ3 issued by Micron’s (MU) management and watched the stock take off (positively) in after-hours trading last Wednesday. The two events didn’t align very well since guidance for the fiscal third quarter came in below analysts’ expectations.
It’s clear there wasn’t too much to celebrate, yet the stock jumped. Some of my fellow contributors also felt the negative guidance meant doom and gloom for Micron for the rest of the year. However, just making a numbers comparison doesn’t bring about medium-term expectations for the memory industry, nor does it tell us what Micron is expecting in the latter half of this calendar year – beyond what the current quarter’s guidance suggests.
Second Half Recovery Still On Track
Some commenters on several Seeking Alpha news posts and articles repeatedly mentioned management’s saying of “low visibility.” However, this low visibility does not mean the company doesn’t have an idea of what its customers are doing or planning to do. Considering large memory orders are negotiated ahead of time, and even before that point are in talks with customers about their needs, it’s not hard to consider Micron’s visibility out at least three months from now.
Now, what exactly management is expecting in three months? In the prepared remarks CEO Sanjay Mehrotra gave this color:
…as we discussed on our last earnings call, we still expect DRAM bit shipments to begin increasing in our fiscal Q3, with demand growth strengthening in the second half of calendar 2019 as most customer inventories are likely to normalize by mid-year.
Further into the call, an analyst asked a question about how management had confidence in the second half of the year and more specifically in the FQ3 pickup of DRAM shipments and management responded with:
If the consumption of DRAM by our customers in the end markets, particularly cloud market continues to be healthy, it’s just that those customers are using up their inventory to meet that demand. And over the course of next few months, by mid this year, that inventory will be returning to normalized levels to a large extent, and then that will provide for opportunities for a greater demand in the second half of the year compared to the first half.
Considering this downturn started due to elevated inventory at customers, a return to normalized levels by mid-year would mean a return to demand from these same customers – which is precisely what management expects.
Even if trade worries continue into the spring, customers are still going to have to pull at their still elevated inventories. Once those inventories are normalized – as Mehrotra put it – the pull from semiconductor companies will resume.
What About Inventory And Idling Wafers?
Moving onto the second portion of Micron’s initiatives which includes carrying higher inventory levels as well as idling 5% of both DRAM and NAND wafer starts, analysts were confused on how to marry the second half expectations with the execution of lowering shipments. But if one were to step back for a minute, they’d realize this makes sense.
Considering inventory builds are typical in downturns of the industry combined with the fact only three major players remain this time around, it’s not incomprehensible to see 150 days of inventory expected. Of course, this is the highest it has been in any downturn, but just a year ago many bears argued the oligopoly means little and it won’t make a difference. Instead, this is proving the oligopoly would rather carry inventory then sell into low pricing in order to gain market share. Furthermore, why would any of the major three decide now, this far into the process, to clobber the market they are working hard not to let the bottom drop out of? It’s not a logical premise to a bear thesis.
But how does one reconcile the 5% idling of wafers? Surely if Micron was expecting a second-half recovery it should be ramping and getting ready to sell all it can into the recovery to return to sequential revenue and earnings growth. Again, stop and think about where the industry is today compared to where it was two or three years ago. With only three players in this downturn, this is a never before occurring situation. Meaning, Micron will be playing a part in helping create this second half of the year recovery.
If supply was not moderated along with expectations for demand (aiming for balanced supply/demand), then the recovery would not continue on track and would continue to be pushed further out. Perhaps, even, it would not happen at all as the rise in demand in the second half of the year would be met with supply targeted for a demand expectation of six months ago. This would continue an imbalance in the supply and demand structure and result in an imbalance only much higher demand could fix.
Marrying The Narrative With Guidance
The reason the market has not punished (down 2% since earnings does not fit the definition of punished) Micron is mainly due to the numbers showing relative strength at what appears to be the bottom of the downturn. FQ3 guidance is what the prior cycle tops were at their best. Margins, revenue, net income are all still above or at prior highs.
But how do we know this is the bottom, aside from management telling us a better year is ahead? What the market is looking at is the rounding of the bottom; the signal the worst expectations are behind the business.
(Source: Micron’s earnings reports, FQ3 guidance, and author’s FQ4 estimate)
The above chart shows the earnings growth over the last three quarters, plus guidance for the current quarter plus my estimate of $0.60 in FQ4 EPS. Notice how the deceleration of earning has begun to shift in the last quarter and guidance created a rounding of the bottom. Even with a sequential decline in earnings for FQ4, the growth rate continues its move back toward 0%, heading for a return to growth.
The above chart shows the correlation between the last cycle’s low in 2016 into the rise in 2017. The inflection in FQ2 2016 and FQ3 2016 is the same point we are seeing going into the second half of Micron’s fiscal year now. It’s apparent the market tracks the rounding of the bottom in terms of quarter-to-quarter deceleration of and re-acceleration of growth.
This is why the company can issue downside guidance and still have the market respond well – it’s in the expectations of negative growth slowing. Therefore, it’s not incomprehensible the market can see the expectations for a better second half, the idling of wafers, and the slowing of negative earnings as Micron tagging the bottom and heading higher fundamentally.
Overall the company has aligned itself for a second-half recovery and is not just spouting a narrative it’s not backing up with inventory adjustments, lowering supply, and matching capex for the expected demand. The company is talking the talk and walking the walk. The market not only sees this but also sees earnings beginning a round-out of the bottom and even with a sequentially lower FQ4 expected, the earnings growth has stopped decelerating and is beginning to turnaround. I’d be a buyer at these levels and hold into the end of the year.
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Disclosure: I am/we are long MU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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