Q3 2022 Earnings Release and Analyst Call

6/30/22

Press Release Commentary

Here are the points from the press release, outside the financial statements, that I found notable:
• Industry demand for memory has weakened recently and the company is taking action to “moderate” supply growth in FY-23, which begins in September of 2022
• During the third quarter the company repurchased 13.8M shares for $981M, an average price of $71.09 per share
• They raised their dividend by 15%, to $0.115 per share, still a small percent of cash available to owners

Financial Statements

Statements of Operations

Lost in the current bear market and declining pricing environment is the fact that Micron had its highest ever quarterly record in Q3. $8.64B eclipsed the previous record of $8.44B, set in the fourth fiscal quarter of 2018. The memory market is much bigger now than it was four years ago, as is Micron’s share of it. The big difference between the 2018 record quarter and this one is that record revenue from 2018 was on a gross margin of 61.0%. The then-record revenue was the result of highly favorable pricing. In the third quarter of 2022 gross margin was 46.7%, the fourth consecutive quarter of GM in the 90-bps range between 46.4% and 47.3%. Gross margin dollars were $4.04B. Micron’s current management team is good at controlling expenses. Overhead was down slightly in the quarter, flat SG&A and lower R&D. The R&D reduction may not all be cost control, because timing of product qualifications swings this item significantly from quarter to quarter. But Micron has managed this spending well for the last few years. There was a meaningful operating expense last quarter that was one-time, but most of the quarter-over-quarter improvement in operating income was because of higher revenue and flat gross margin. The company had $3.0B of operating cash flow, an operating margin of 34.8%. Interest income, while small, nearly doubled from the previous quarter. Interest income declined 20% from last quarter. Management is taking advantage of higher interest rates in their investments while at the same time benefitting from the recent restructuring of some debt at a lower rate. 12.0% was provisioned for income taxes, compared to 10.2% last quarter. Earnings per diluted share were $2.34, up 15% from the $2.00 last quarter. The diluted share count of 1.121B is the lowest level in four and a half years, going back to when the current executive team joined the company, and the swelling of share count that came from all the equity that was granted to them when they joined. I’ll be impressed when management gets the share count under 1B. Most of the buybacks they have done during their tenure have not accrued to shareholders. They have just offset dilution from grants to executives and employees.

Cash Flows

As an investor, I care most about cash flow, as opposed to earnings ratios, price to book value, etc. Watching cash flow is especially important with Micron because their capital expenditures are so high. This is the nature of leading-edge semiconductors. To calculate owner’s cash flow in Micron’s case, I add back in a portion (28%) of stock-based compensation in the operating cash flow calculation. See below in the “Share Repurchases” section to get my full thinking on this. The abbreviated version is this; historically, 72% of Micron’s share buybacks have gone to offset dilution from equity compensation. I also took out the effects of changes to working capital, which lowered Micron’s free cash flow substantially. As the market has weakened this year, the company has increased the amount of inventory they are holding. This will reverse when the market recovers, or when Micron lowers output to the point where some demand is served with bits out of inventory, as they have said they will do. In doing this, I am assuming they don’t have to substantially write-down the value of this inventory. Finally, $8.45B worth of capital expenditures has been spent in the first three quarters of this year, leaving $4,348M in owner’s cash flow in the first nine months. This annualizes to $5,797M, an owner’s cash flow yield of 8.8% at the current share price around $60. This is a tasty cash flow yield, but that is because Micron is a price taker. The market is anticipating memory prices to decline faster than cost per bit in the foreseeable future, thus lowering future free cash flow.
The $8.45B of capital expenditures is well above the $5.2B in depreciation and amortization so far in FY-22. These two items will converge in the coming years, which will reduce earnings, all else equal. Earnings and cash flow will get closer together as this happens. A net $1.6B was invested in working capital this year. Management, seeing storm clouds in the offing, has moved about $160M during the quarter from available-for-sale securities into cash, reversing the trend from the first half of the fiscal year. They also refinanced $2B in debt to a lower interest rate, an event that was almost neutral with respect to cash flow. Of the $4.35B in owner’s cash flow generated in the first three quarters of the year, $1.98B was returned to shareholders in share buy-backs or dividends, 83% in buybacks. As a shareholder, I hope Micron’s management team is a lot better in the next few years in buying back stock than they have been since Mehrotra took over. If not, three-quarters of the cash flow they claim to be returning to shareholders will not actually make it to owners. It will be going to employees, a disproportionate amount of which is granted to the executives of the company.

The Balance Sheet

Micron’s total cash position has increased $1.4B so far in the fiscal year, to $9.2B. They have a further $1.1B of short-term investments. All of this is against a little under $7B in total debt, for a net cash position of about $3.3B. They have a further $1.6B in long-term marketable securities, so call it almost $5B worth of net cash and investments. Inventories have grown from $4.5B to $5.6B in the last three quarters. It is surprising that most of this growth happened in the first half of the year, with only $140M added during Q3. This surprises me because I am in the mindset already of weak demand. But that is the forecast for Q4 and beyond. Q3 was still a strong quarter for Micron. The growth of inventories is a combination of replenishing memory from the low levels earlier in the year, stocking up for anticipated higher demand in the remainder of 2022 (which they foresaw three months ago) and stocking up on inputs needed amid supply chain constraints. Book value rose to $49.3B from $47.8B at the end of last quarter. This is an equity value of $43.96 per share.

Share Repurchases

At the end of FQ4-21, the company had 1.138B diluted shares. Nine months later, at the end of FQ3-22 there were 1.121B diluted shares outstanding, so share count decreased by 17M shares. At $60 per share the value of this share count reduction is $1.02B. The company spent $1.65B to get this. At $75 per share, this number of repurchased shares is worth $1.275B. Going back further in time, Micron has spent a net of $2.584B buying back stock from FY-17 through FY-21, inclusive. Adding in the $1.65B in FY-22 to date, a total of $4.234B of cash has gone to buying back stock. There were 1.037B diluted shares at the end of FY-16. Share count today is 1.121B, so share count has declined 16M in the last five years and nine months, at a total cost of $4.234B. 16M shares at $60 per share is $960M in value back to shareholders. Even at the all-time high share price of $98.45, this is $1.575B of value to shareholders, a loss of $2.659B of free cash flow. To try and reflect share price through-cycle, I’ll use a share price of $75. At this value, the 16M share count reduction since Mehrotra took over has a total value of $1.2B, which is 28% of the cash that was supposedly returned to shareholders. Thus, 72% of this cash was just to offset dilution. For now, I’ll use this ratio of the stock-based compensation. That is to say, I will subtract 28% of this from earnings in the operating cash flow calculation rather than the full amount, to reflect that historically only 28% of the cash flow “returned to shareholders” in this way actually makes it to owners. The other 72% offsets dilution from equity grants. I understand this is an imperfect way to estimate the cost of dilution, but it is better than nothing, and it is better than ignoring the problem.

Conference Call

Numbers given during the conference call are non-GAAP.

Sanjay Mehrotra (President and CEO)

• This quarter was a record for quarterly revenue
• The company is ahead in both DRAM and NAND technology at the leading edge of process technology
• Micron’s 1-alpha node was the largest node in DRAM shipments during the quarter
• Cost reductions in both DRAM and NAND are expected to outpace the industry in 2022
• COVID-19 control measures in China at outsourced assembly and test contractors affected revenue in Q3
• Mehrotra cited a target for the company’s mix of segment sales to be more heavily weighted to “higher margin” segments, such as automotive and industrial. But he also included data center, which is the fastest growing segment, in absolute terms. The segment sales he suggests getting richer for Micron may just be a result of how the overall market distribution changes. And lumping data center together with automotive and networking, as he did, isn’t meaningful because the spread in ASPs across these segments is relatively large.
• Mehrotra went on and on about the company’s wide product portfolio, customer relationships, etc. These comments are almost meaningless because all of what he talks about, at least with respect to DRAM, does not gain Micron much in pricing power relative to Samsung and Hynix.
• Smartphone unit volumes are expected to decline mid-single-digit percent in 2022 compared to 2021. This softness in mobile is hurting memory demand.
• Their expectations for bit demand growth for both DRAM and NAND have “moderated” in the last 90 days. Weaker consumer demand is caused by weakness in China, inflation worries, and the Ukraine war
• Industry bit demand growth for 2022 are expected to be below the long-term averages of mid-to-high teens percentage in DRAM and high-20s percent in NAND. They continue to see these averages to be valid in the long term.
• Micron is lowering bit growth plans in FY-23 (which starts in September) to respond to demand weakness. They will reduce capex in FY-23 to a level below FY-22 and will close any supply gaps with inventory.

Mark Murphy (CFO)

• DRAM was 73% of total revenue in the third quarter. DRAM revenue was up 10% quarter-over-quarter, bits were up slightly more than 10% sequentially, and ASPs declined slightly Q/Q.
• NAND was 26% of revenue in the quarter and was up 17% Q/W. Bit shipments in NAND were up high-teens percent Q/Q and ASPs declined slightly Q/Q.
• The small (40 bps) decline in non-GAAP gross margin was because of more NAND in the overall mix
• OpEx is expected to increase sequentially in Q4 because of the timing of product qualifications
• Total capital expenditures for FY-22 is expected to be approximately $12B
• The company has liquidity of $14.5B as of the end of the third quarter
• During the quarter, the company spent $981M on share buybacks, to repurchase 13.8M shares. Murphy said they are committed to returning 100% of free cash flow to shareholders over the cycle through a combination of buybacks (both programmatic and opportunistic) and dividends.
• FQ4-21 non-GAAP guidance: revenue of $7.2B +/- $400M, operating expenses of $1.05B +/- $25M, GM of 42.5% +/- 1.5%, diluted EPS of $1.63 +/- $0.20, based on 1.13B diluted shares. Besides the big down in financial performance, the ranges around the lower revenue, earnings, and margins are much wider than previously, which shows how much more uncertainty management has about the near future.
• Sequential bit shipments are expected to be down for both DRAM and NAND in Q4
• OpEx and CapEx reductions will be “more material” in FY-23

Analyst Q&A

• End market demand in servers and cloud are both healthy. Cloud is carrying more inventory than they did pre-COVID. It hit me again listening to this first answer, which was from Mehrotra, how much he likes to hear himself talk. He could get his messages across in half the time if he were a concise speaker.
• PC unit growth is now forecasted to be down 10% in 2022 year-over-year
• PC and smartphones combined are half of total worldwide memory bit demand, combined DRAM and NAND
• One analyst asked a critical question, how much cash are they willing to significantly take down the share count by taking advantage of the current low share price. Murphy declined to give much of an answer on this, besides saying it will likely be higher in Q4 than what they bought back in Q3.
• Their inventory declined from 113 days at the end of Q2 to 109 days at the end of Q3, thought inventory is expected to grow in Q4 and possibly beyond. Murphy said up “a couple weeks and days” in Q4 is the growth they expect. 150 days of inventory is the level where they start to get uncomfortable.
• When asked about future demand, Mehrotra said he thinks demand will recover in FY-23, so sometime in the next fourteen months. This is a forecast from a guy who, ninety days ago, thought the rest of 2022 would see strong and increasing demand. I don’t say this to pick on the CEO. I say it to remind readers that the memory market is very hard to predict, so it’s not useful to get too high or low based on forecasts.

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

• Stood by their 30% guidance for through-cycle operating margin
• Two-thirds of the guide down sequentially for Q4 is from lower bit volume, so the remainder is lower forecasted ASPs
• Inventory corrections at customers typically take a couple of quarters, assuming stability in the demand of their segments. So, if demand doesn’t continue to deteriorate at PC and smartphone customers, they will get back to normal inventory levels by the late Fall of 2022
• Sadana again said some memory demand, specifically for servers, is tempered today because of supply chain shortages
• Micron’s forecast for revenue coming out of China has declined 30% from what they forecasted during the call one quarter ago
• The company’s inventory level is lower in DRAM than in NAND
• LTAs with customers are most useful to keep demand and supply in balance, by preventing customers from over-ordering and driving excess supply growth

Summary

One quarter ago things were expected to get better as 2022 progressed. Now they are battening down the hatches. This has been the strangest cycle I’ve seen in more than two decades of owning and following Micron. The stock is down now below $60 per share in anticipation of demand, and thus pricing, weakness. Nobody knows how long the weakness will last or how bad it will be. This quarter was a record for a company and pricing only declined slightly. The low share price is because the overall tech market is well into bear territory, and because when demand declines in memory, nobody knows where it will stop. I won’t even venture a guess as to what will happen. I’ve been wrong too many times since COVID hit and have no reason to think I’ll be more right in the future. If you want to play the memory cycle, this would typically be too early to start buying. There are usually at least four quarters of pain before things recover. But since the Pandemic hit, history has not applied. Micron is taking action, lowering bit growth and contemplating lower fab utilization to reduce supply growth. They will also grow inventory rather than let pricing collapse. Sadana said something that gave me optimism that cycles will dampen in the future, the fact that most big customers have LTAs with the major DRAM makers. This makes it less likely the overall DRAM industry will overbuild and overshoot demand. This won’t prevent cycles, but it should help to dampen them. As for this cycle, I hope it is short and I hope the recovery matches up with a rebound in equity valuations. I’d still like to be out of my Micron position by the end of calendar 2022, though the odds of that are much lower than they were three months ago. I’ll be closely watching what Samsung and Hynix say in their earnings reports in the next couple weeks.

-S. Hughes (long MU)

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