Forget what you've heard, the market is not rational. Major news events should have a major impact on stocks that are affected. But investors get so caught up in the rest of the market noise that they can miss these momentum-shifting events. Case in point: A stunning legal verdict in favor of Micron Technology (NYSE: MU) that has yielded almost no gain for investors. I recommended this stock back in September, calling it my top pick for the ongoing migration to tablet computing.
Micron is a leading provider of computer memory. Its traditional DRAM memory business is highly cyclical and generates very weak margins at low points in the cycle, as is the case now. But Micron is also a leading provider of flash memory, which is used in an expanding range of computing devices such as smartphones and tablets. This kind of memory carries much better margins and is the key to the company's future, because it will soon represent more than 50% of revenue.
Shares of Micron had been under pressure -- selling far below book value -- for a pair of reasons. First, dismal memory pricing led to a pair of weak quarters that forced Micron to miss consensus profit forecasts. Second, investors were preparing for a potentially disastrous legal verdict. Rambus (Nasdaq: RMBS) sued Micron and Korea's Hynix in 2004, claiming that those two firms had engaged in practices that harmed Rambus' entry into the memory market. Virtually everyone assumed that Rambus would prevail. Estimates of legal damages ranged from $300 million to the eye-popping $4 billion Rambus was seeking. (Had Micron been found guilty, a judge could have awarded treble damages, or up to $12 billion!) Most seemed to focus on the round number of $1 billion.
But the judge bucked conventional wisdom, ruling against Rambus on Nov. 16. Suddenly, investors realized Micron's $2.5 billion cash hoard would remain untouched, and the stock was swept up in a furious 23% one-day rally. "One of the largest event risks around the stock has been removed -- namely, the need for Micron to potentially raise additional capital to post a bond against a much larger judgment," note analysts at Goldman Sachs.
Equally important, it quickly became apparent the decision was unlikely to be challenged. "The case can be appealed by RMBS, but 1) given that the Jury deliberated for almost 2 months (Closing arguments ended Sep 21), and 2) the Jury was given 100-200-page detailed instructions, an appeal will be significantly tougher," noted analysts at Sterne Agee after the decision was announced.
Well, the pullback shouldn't be a complete surprise, as the S&P 500 dragged down everything in its wake, falling from 1,258 on the day before the verdict was announced on Nov.15 to 1,159 by the end of last week. Yet for those who failed to profit from the legal announcement back in mid-November, you've just been handed a second chance.
With the legal risk removed from the story, investors can once again focus on the fundamentals. As noted in my September profile of the company, this year has been a lost year, thanks to lousy pricing for Micron's DRAM memory modules. (DRAM stands for Dynamic Random Access Memory and is used to store data that are most frequently accessed by a computer. The more DRAM a system has, the less power it needs to get data from less accessible data that is stored on the hard drive). Yet as I also noted earlier, Micron's NAND flash memory division is now gaining real traction and now accounts for nearly half of sales. In the company's fiscal fourth quarter ended August, flash overtook DRAM for the first time, accounting for 41% of revenue against 36% of sales for DRAM. (The remainder involves the company's USB-memory devices.)
By early 2012, higher-margin flash memory should account for more than 50% of the sales mix, according to Sterne Agree. (NAND -- which stands for Not AND, a coding language, is used in USB-storage devices, memory cards, solid state drive hard drives and other mobile devices).
This shifting sales mix sets the stage for solid free cash flow in coming quarters, as firming profit margins should come at a time when capital spending (CapEx) hits a multi-year low. Micron generated $2.5 billion in free cash flow in fiscal (August) 2010, but a big hike in CapEx led to a $66 million free cash flow loss in fiscal 2011. In the current fiscal year, analysts expect free cash flow to take off in the quarters that end next May and August. Goldman Sachs anticipates more than $1 billion in free cash flow in the current fiscal year and almost $1.5 billion in free cash flow in fiscal (August) 2013. This works out to a projected free cash flow yield in excess of 20%. More specifically, Goldman Sachs anticipates Micron will generate $2.98 billion in operating cash flow in fiscal 2013, with roughly half that amount eaten up by capital spending. Micron's cash, which stood at a recent $2.5 billion, could rise to $4.6 billion by the end of fiscal 2013, according to Goldman Sachs. This works out to more than $4 a share.
Sterne Agee, which says shares could trade to at least tangible book value of $8 (shares currently trade for less than $6), have a $13 price target, which equates to 1.2 times tangible book value a year from now. They note that other flash-memory players trade for about 2.5 times book value.
Risks to Consider: The flooding in Thailand is expected to create a shortage of traditional hard drives in coming quarters. Although Micron does not have operations in Thailand, PC makers are likely to see a supply shortage of hard drives that affects the manufacturing of new PCs, possibly blunting demand for other components such as memory as well. Then again, production problems for traditional hard drives could open the doors wider for Micron's solid-state hard drives, which rely on NAND flash.
Action to Take--> Micron sports a very strong balance sheet, which explains why shares have mostly had downside support in the $5.25 range (with the exception of a sub $5 dip in September on fears of an onerous Rambus verdict). The upside ranges from good to great. Just a move back to tangible book value implies 45% upside. A rebound to Sterne Agee's $13 price target means this stock could double in 2012. Either way, the risk/reward looks awfully compelling.