The One Chipmaker Poised To Beat Industry Headwinds
For more than a decade, the business of making memory chips was a lousy one. The industry had ample excess capacity and pricing power was non-existent.
And then the management team at Micron Technology, Inc. (Nasdaq: MU) decided to change all that. They correctly understood that by acquiring rivals — and then closing down excess manufacturing capacity — they could drive up prices and profits.
I looked at this issue in 2012 and shares of Micron eventually soared to $36 from around $6.
#-ad_banner-#A healthy supply/demand environment similarly created robust gains for rival chip-maker SanDisk Corp. (Nasdaq: SNDK).
Not only have these firms benefited from more rational supply trends, they are also benefiting from a powerful growth driver: surging demand, as solid state memory (also known as “flash memory”) is used in a proliferating number of electronic devices. Even personal computer manufacturers are making the switch from disk drive storage to solid state storage in many high-end machines.
Yet even the best industries experience temporary headwinds. A recent modest pullback in demand and pricing has led to sharp share price pullbacks for both Micron and SanDisk. In my mind, only one of these two firms is poised for a solid rebound.
To be sure, these two firms are subject to similar industry dynamics. Recently revised guidance regarding sales and pricing trends has led to a sharp reduction in consensus profit forecasts for both of them.
Yet these firms also have a distinct difference: SanDisk is first and foremost a provider of a type of memory known as NAND. Micron is mostly focused on DRAM, but also has exposure to NAND chips.
NAND is a type of (expensive) flash memory that has robust capabilities and is especially suitable in applications that require data to be saved within memory when a device is turned off. Trouble is, flash memory is subject to increasing competition from firms such as Samsung.
DRAM, or Dynamic Random Access Memory, is better suited to larger scale memory needs, but information is not saved in this memory when a device is turned off. DRAM is also much faster than NAND, known in the trade as having “faster seek times.”
The 35% drop in shares of SanDisk since December is quite understandable, as the company has encountered a series of headwinds in recent quarters. It had been a key supplier of flash memory to Apple, Inc. (Nasdaq: AAPL), but Samsung has snagged key contracts and Apple may be morphing into a rival instead of a customer. SanDisk has also had trouble with its manufacturing processes, which may explain why the company cancelled a planned Analyst Day for May. In effect, management can be sure that such troubles will persist for a while to come. And it’s wiser to stay off of the investor radar for now.
Some of the company’s challenges are external. SanDisk’s management, for example, decided to simply stop pursuing new business at Apple in recent months. “While the loss of the Apple SSD (solid-state drive) business is painful in the short-term, it is important to note that margins on that business was already poor, so it probably made sense to pass on the deal with Samsung pricing aggressively and Apple starting to take SSDs in-house,” wrote analysts at Citigroup.
In contrast, Micron is seeing much more stable trends in the DRAM end of the business. That’s the result of industry consolidation. The number of producers shrank from 40 a decade ago to just three currently.
“The three remaining vendors have become better in negotiating pricing with their customers and managing inventory in the channel,” note analysts at Pacific Crest Securities, adding that this is “leading to lower DRAM pricing volatility, which benefits the DRAM industry and Micron.”
It’s the relatively greater exposure to DRAM that explains why Micron is poised to deliver smoother results — and more robust free cash flow than SanDisk. While Micron’s free cash flow is likely to fall by a third in fiscal (August) 2015 to around $2 billion, analysts at Merrill Lynch expect that figure to soar to $4 billion in fiscal 2016 and fiscal 2017.
Meanwhile, SanDisk’s relatively higher exposure to flash memory — and the tougher competition in that space — means that free cash flow is likely to be stuck around $1.5 billion in 2015, 2016 and 2017.
Micron’s soaring free cash flow is expected to lead to robust growth in share buybacks and dividends. That’s because the company has already done the heavy lifting in terms of expenses associated with acquisitions and factory modernizations.
Micron announced its first ever buyback in October 2014 (for $1 billion). When that plan is completed this summer, look for an even bigger one to replace it, especially now that shares are well off of their highs.
Risks To Consider: A sharp drop in PC sales would hit Micron especially hard, as its DRAM chips remain quite popular with PC manufacturers.
Action To Take –> Shares of Micron have been under pressure due to a modest pullback in chip pricing. Management compounded matters by deciding to hold on to inventory in the current quarter, rather than selling it at reduced prices. Analysts view the move, coupled with lower guidance, as a way of clearing the decks before better results in future quarters. Analysts at Credit Suisse think that has created a great entry point and see shares nearly doubling to their $50 target price: “With the reset quarter in arrears; we see very compelling risk/reward,” they note.
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