Q1-23 Earnings Release and Analyst Call

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12/21/22

Press Release and Investor Presentation Commentary

Here are the points from the press release, outside the financial statements, that I found notable:

  • They expect customer inventories to normalize such that they will see higher revenue in the fiscal second half of 2023. This reads to me to be saying that the second half of their fiscal year – the period from March to August of 2023 – will have higher revenue than the first two quarters. Their comment in the press release is clarified in the investor presentation. Management is forecasting their revenue in the second half to be higher than the first half. For this to happen, the memory market must turn up in the March to August timeframe, inclusive. If the turn happens later in the half, it must be steeper, for the total revenue to be higher in the second half. Regular readers of my posts may recognize this to be my “Scenario 2” for market recovery, based on downturns historically being five to six quarters in length.
  • Net investments in capital expenditures in the quarter were $2.47B, resulting in free cash flows of negative $1.53B
  • The company repurchased 8.6 million shares of its stock at a total cost of $425M, an average cost per share of $49.40. This is an excellent average purchase price. The shares were only below $50 each for a handful of days in the period. Credit to the executive team in holding their repurchase spending, something they have been consistently poor at in the past. Historically they bought too early in the downturn and bought too much during the mid and up cycle.
  • GAAP guidance for FQ2-23 is revenue of $3.80B +/-$200M, gross margin of 7.5% +/- 2.5%, operating expenses of $1.08B +/-$15M, and diluted EPS of ($0.79) +/- $0.10. Reduced the revenue range by 20% but increased the GM range by the same percentage.
  • Further color on the above bullet was provided in commentary on inventory. The company says their inventory will peak in the current quarter (December to February) and will start to decline after that. This means management believes the recovery in demand will start in the Spring of 2023, so earlier in the second half.
  • The crossover to DDR5 DRAM in the data center segment is expected in mid-2024
  • PC units will decline high teens percent in CY22 and the company forecasts PC unit volumes to decline by low to mid single digits % in CY23
  • Smartphone unit volumes will be down 10% year-over-year in 2022 and are forecasted to be flat to slightly up in 2023 compared to 2022
  • Automotive continues to be strong, growing 30% year-over-year in the quarter, same as in FQ4-22, though growth slowed slightly. The company expects robust growth in 2023 in automotive. I think they are wrong about this because the auto market is in the process of rolling over from its peak, driven by supply chains catching up and higher interest rates suppressing demand.
  • The industrial segment continues to soften, a development first reported last quarter. Micron believes volumes will recover in the second half of FY23, along with the broader market.
  • DRAM bit growth: CY22 industry demand is expected to be low-to-mid-single digit percent, unchanged from their forecast last quarter. Management’s view of long-term bit demand growth is for a mid-teens percent CAGR, same as last quarter.
  • NAND bit growth: CY22 industry demand expected to be low to mid-single digit percentage. This is down from “slightly higher than 10%” that was forecasted last quarter. They revised down their long-term bit demand growth forecast to “low to mid 20% range” from “around 28%.”
  • Supply growth is expected to be “well above” demand growth in CY22 for both DRAM and NAND. Supply growth for CY22 will be around the long-term demand CAGRs for both DRAM and NAND.
  • They expect CY23 demand growth to be well above their forecast for industry supply growth for both DRAM and NAND. They didn’t give any numerical ranges, saying instead that supply growth next calendar year for both memory types will be “well below” their long-term CAGRs.
  • Even though they are forecasting for the market to turn in calendar 2023, they expect industry profitability will “remain challenged” throughout the year
  • As reported last quarter, Micron will have FY23 capital expenditures in a range of $7.0B to $7.5B with WFE spending down more than 50% year-over-year. This is down from the $8B total CapEx they forecasted for the year in the Q4 call. They will reduce FY24 CapEx as well, a new announcement. Specifically, FY24 WFE spending will be lower than the severely lowered FY23 spending, though construction spending will increase in FY24 over FY23.
  • As reported mid-quarter, wafer starts on both DRAM and NAND have been cut by 20%. Further, they are slowing their technology node transitions. They expect their 1-gamma DRAM node will now be in 2025. The NAND node beyond 232-layer will be delayed to align with the new demand and supply outlook, but no dates were provide.
  • The company is cutting discretionary spending and is expected to exit FY23 with quarterly operating expenditures of around $850M
  • DRAM was 69% of total revenue in the quarter (72% in the prior quarter). Revenue was down 41% Q/Q and 49% Y/Y. Bit shipments were down mid-20% range Q/Q and ASPs declined low-20% range Q/Q (declined low-teens % in Q4.)
  • NAND was 27% of total revenue in the quarter (25% in the prior quarter). Revenue was down 35% Q/Q and 41% Y/Y. Bit shipments declined mid-teens % range Q/Q (was low-20s percent in Q4). ASPs declined in the low-20% range Q/Q (was mid-to-high single digits percent in Q4).

Financial Statements

Statements of Operations

Revenue in the quarter was $4.09B, a sequential decline of 38%, following a decline of 23% last quarter. Gross margin was $893M, or 21.9% of revenue. R&D spending was up to $849M, breaking the company record of $839M, set last quarter. SG&A spending was down $29M to $251M, a meaningful reversal from the record spending last quarter. It is easier to cut SG&A spending than it is to reduce R&D. With the severe decline in revenue, operating margin swung to a loss of $(209M) in the quarter. The severity of this downturn is staggering. Two quarters ago, gross margin was nearly at the cyclical peak, coming in at 46.7% in FQ3 of 2022. Using the guidance for the current quarter, FQ2-23, Micron’s gross margin will fall 3920 basis points in three quarter. This is by far the sharpest decline going back to at least 2012. With rising interest rates and a lot of fixed rate debt, the company is making money on the spread between their short-term debt assets and their long-term paper. In this quarter they profited $37M from this. Net loss for the quarter was $(195M) or $(0.18) per diluted share. Last quarter the company made almost $1.5B in profit, an EPS of $1.35. This is a brutal swing, even for the memory business. Diluted share count was 1,090 million, down from 1,106 million last quarter.

Cash Flows

Micron increased their cash position by $1.30B during the quarter by issuing $3.35B of new debt. I’ll go into detail on this in a separate section below. Even with the major reduction in capital expenditures the company announced for this fiscal year, capex was still well above depreciation and amortization for the quarter, coming in at $2.45B vs. $1.92B in D&A. There are two reasons for this. One, capex is front loaded in the fiscal year, with fully one-third of the total happening in Q1. The reason for this is the long lead time on these expenditures, especially fab equipment. Second, Micron has invested heavily in the last few years and hence has high depreciation every quarter. Working capital consumed $911M of cash. The largest driver here was the growth of inventory (almost $1.7B, more on that below) because of the weak market. This was partially offset by the company pulling in cash from receivables, though other companies did the same to Micron, to a lesser degree. Cash from operations was $943M in Q1. With the high capital expenditures always required by this business, even in times of lower investment, free cash flow swung to a loss of $(1.51B) in the quarter, or $(1.38) per share. That annualizes to a massive cash outflow of $(5.53) per share per year. To staunch the bleeding some the company liquidated a net $268M of available for sale securities. They bought back $425M of stock, only two-thirds of which went to shareholders as the other third offset dilution from share grants to executives and employees. The company paid $126M in dividends in the quarter. In summary, a massive new debt issuance ($3.3B) and cash flow from operations offset $2.5B in CapEx and $1.7B in new cash tied up in inventory.

The Balance Sheet

Because of the sharpness in the drop in memory prices and the resulting loss of revenue and earnings for Micron, the company’s book value declined for the first time in three years. The two most concerning items on their balance sheet are inventory and debt. Inventory rose from $6.67B three months ago to $8.36B at the beginning of December, an increase of 25%. The company added $18.8M to their inventory balance every calendar day of the quarter. Five quarters ago, when the CFO said their inventory levels were too lean, they were below $5B in total value. Micron’s cash balance rose to $9.57B, plus another $1.01B of short-term investments, in the quarter, because new debt offset cash spent on capital expenditures and consumed by growing inventory. The company’s net cash position, including short-term investments, was $316M at the end of the first quarter. This is effectively zero, considering the cash and debt totals are both just above ten billion dollars. Property, plant, and equipment is nearing $40B. This will be a milestone of sorts considering PP&E was below $10B in 2015. What a capital-intensive business this is to have grown the balance of capital investments by 4x to generate, at the peak three quarters ago, about 2x the revenue. With the price decline this year, quarterly revenue is now the same as it was in 2017.

New Debt

On October 31, 2022, the company issued $750M of senior unsecured noted that mature on November 1, 2029. This new debt has an interest rate of 6.75%. The company can close this debt out early at a cost of the remaining principal value or the sum of the present value of the remaining principal and interest, plus the accrued interest. On November 3, 2022, the company borrowed an additional $2.60B in aggregate principal amount, in three tranches. These tranches are $927M due November 2025, $746M due November 2026, and $927M due November 2027. The three tranches have varying repayment term requirements and have variable interest rates of SOFR plus 1.0% to 2.0%. This term loan also contains leverage requirements. I think issuing this amount of new debt is a window into what the executive team is thinking. While their public statements are that the market will turn within the next six months, they have serious concerns that something else will go wrong (recession, etc.) and the downturn will drag on to late 2023 or beyond. Adding this debt now is a measure of insurance against that.

Conference Call

Numbers given during the conference call are non-GAAP.

Sanjay Mehrotra (President and CEO)

  • The DRAM and NAND markets have not been this far oversupplied in thirteen years, since the downturn that coincided with the Great Recession
  • They believe aggregate customer inventories of memory are declining
  • Demand is expected to gradually improve in the coming months as customer inventories normalize and China opens up
  • They took down their long-term demand growth CAGRs because of lowered growth expectations for the PC, mobile, and cloud markets. They now see DRAM long-term bit CAGR of mid-teens percent and NAND in the low-to-mid 20% range.
  • Micron’s CY23 production bit growth will be negative in DRAM and up slightly in NAND. This reduction will be throughout the year as evidenced by the company announcement that they will lower capital expenditures in FY24 from the greatly lowered levels of FY23.
  • Spending in FY23, including headcount reductions of ~10%, suspension of bonuses, reductions in executive salaries, and reductions on other discretionary spending

Mark Murphy (CFO)

  • As was the case last quarter, all four business units were severely down. In this quarter, revenue declined sequentially between 23% (Embedded BU) and 57% (Mobile BU)
  • Days of inventory are expected to peak before the end of February 2023 and begin to decline after that
  • The company had $14.6B of total liquidity as of the end of the first fiscal quarter
  • The investor deck states the company had a net cash position of $1.8B as of the end of FQ1-23, much more than my commentary above. This is because they are including long-term investment in their total, which I did not. This asset class had a total balance of $1.426B as of the end of the first quarter.
  • COGS will experience a $460M “headwind,” mostly because of underutilization. This will be weighed in the second half and will continue into FY24. Excluding this, DRAM cost per bit reduction will be “healthy” while NAND will be “challenged.” Their NAND costs are under pressure because of higher energy costs in Singapore, where almost all their NAND is manufactured.
  • Their forecasted CapEx in FY23 has again been reduced, now to a range of $7.0B to $7.5B, including a more than 50% reduction in WFE spending.
  • Management has suspended their share buyback program for the foreseeable future, pending a recovery in the memory market. While better than in past cycles, management still missed a giant opportunity to reduce their share count because they mistimed their share repurchases.

Analyst Q&A

  • Micron’s DRAM production will be slightly negative in calendar 2023, the CEO clarified on analyst’s comment. The analyst asked if they believe Samsung and Hynix are also reducing supply. Sanjay declined to give an answer.
  • Thanks to Tim Arcuri for his second question on Micron’s process technology leadership. It led to Mehrotra going on a five-minute marketing speech about Micron’s technology and how great it is but gave almost no useful information.
  • Third fiscal quarter of their 2023 will be the peak of inventory dollar value, while Q2 will be the peak of DIO. Their cost per unit will go up because of underutilization charges caused by the decision to lower wafer output by 20%. This comes from their fixed capital equipment in both fabs and in assembly and test being underutilized. Cost per bit will be up in Q2 and Q3 as the lower volumes flow through their manufacturing machine and into inventory.
  • There were no inventory write-downs in Q1, but Murphy acknowledged that the risk of write-downs exists in the future, depending on how much more the memory market deteriorates
  • Their Q2 forecast implies bit shipments to increase. Further price declines are offsetting more volume, leading to lower revenue.

Post Earnings Q&A call with Mark Murphy (CFO), Sumit Sadana (CBO) and Manish Bhatia (VP of Global Operations)

  • Gross margin in FQ2 would be 5.5% without the one-time insurance settlement
  • The company is assuming 10-20% underutilization reduction of their manufacturing capacity through the end of FY23
  • In the second quarter the company expects to be at 214 days of inventory. That is a lot.
  • The underutilization of their factories will continue until they see market conditions improve. That is a bold statement.
  • Total PC unit sales are on track to reach the level of 2019, before the Pandemic
  • Accounts receivable will be flat in the second quarter, which will hurt free cash flow as inventories continue to build. With their forecast for business improvement in the second half, they expect free cash flow to improve, but to still be negative for the full fiscal year 2023. It is good to remember here that the memory company executives don’t know anything, just like the rest of us.
  • The company is committed to positive free cash flow in fiscal year 2024. This is worth noting even though commentary on the market nine months from now is almost useless.
  • Server customer inventory will take longer to reach a healthy state than other customers, such as PC and mobile

Summary

This is the worst downturn Micron has experienced since the Great Recession. Revenue fell more than 50% in two quarters. Gross margin was almost 47% in the third quarter and is forecasted to be 5.5% three quarters later. I have never seen a drop so steep. Back in September, the executives forecasted Q2 to be financially similar to Q1. For sales, it is not that far off, but profitability is forecasted to be much lower than in Q1. This is, I believe, mostly because of the underutilization costs caused by the reduction in wafer starts of 20% for both DRAM and NAND that was announced during the quarter. They further reduced FY23 capital expenditures, from $8B to a range of $7.0B to $7.5B. Management also plans to reduce CapEx in FY24 to levels below FY23. This is a bold statement and is caused by their down-revision in the long-term demand growth for DRAM and NAND, as well as the severity of the downturn. They kept their long-term DRAM demand growth rate the same (mid-teens percent) but again reduced long-term NAND demand, from 28% to low-to-mid 20% range. I wonder if the 2017-18 super-cycle caused Micron to over-estimate the long-term memory demand rates and this downturn has caused the down-revisions. Inventory built again to another record level. Demand weakness has finally spread to servers, the last bastion of strength since the cycle turned down two quarters ago. Micron has made major cuts to their supply growth which have so far not been matched by competitors. Hynix and Samsung will report in January and hopefully they will announce reductions as well. Micron is risking loss in market share, especially in DRAM. The word that describes this quarter is fear. Micron’s executive team added more than $3B in new debt, cut wafer starts, slowed technology migration, suspended bonuses for employees, reduced capital expenditures planned for the next six quarters, and announced a 10% reduction in headcount. They have taken the most severe action I’ve ever seen from Micron in response to falling memory prices. They are forecasting customer inventories to normalize in the second half of the fiscal year and for their revenue to recover then. While this is based on smart people with the best available information, it is important to remember the cycle is difficult to forecast. If the global economy contracts next year, this downturn will continue and maybe get even worse. One notable improvement is the company released their 10-Q at the same time as their earnings announcement, something that shows they have their internal finance machine running well. This quarter demonstrated in the starkest terms that Micron is still not a company suitable for long-term investing. In the words of a Micron analyst more than twenty years ago, they are an airline with fabs attached. The business is extremely capital intensive and they have no pricing power. Micron is a great cyclical investment, at least it can be. With cyclicals, one can make a lot of money if they get the cycles right. When the cycle does turn up in memory, I think the share price will be back over $80 in short order. One closing observation. The U.S. government’s action against YMTC will help bring the NAND market closer to supply-demand balance, because it will be harder for that Chinese entity to grow their production volumes.

-S. Hughes (long MU)

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