An Excellent Semiconductor Bet

Mohsin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Micron (NASDAQ: MU)is one of the most underappreciated stocks in the entire technology sector. Despite industry headwinds, macro-economic weakness and extremely strong competition, Micron has been able to diversify away most of its troubles.

The DRAM industry has taken a lot of beating in the last couple of years and I believe, after major consolidations last year, it will significantly stabilize in 2013. Micron is by far the best play in the memory industry and offers a 20% upside at these levels.

Let's dig in

Micron is among the world’s leading semiconductor manufacturers and has a market capitalization of $7.6 billion. It is involved in the manufacturing and sale of semiconductor products for markets all over the world. The company supplies DRAM products for both PCs (DDR2, DDR3 etc.) and handhelds (low-power DRAM, SDRAM).

The demand for DRAM products has been steadily falling due to a major industry shift. The PC industry is more focused on creating leaner and more efficient OS and programs which use up less memory. Moreover, the shift from PC computing to handheld computing has been a major factor in reducing the demand for Micron’s PC focused DRAM products.

The company has successfully diversified away the adverse impact of these factors. To reduce its reliance on PC DRAM products, it has successfully improved sales of its low power DRAM products, aimed at handheld devices.

Moreover, to reduce overall contribution of DRAM segment, Micron has diversified into NAND flash memory and NOR products. The progress in this regard has been beyond phenomenal, and, for the first time in the company’s history, less than 50% of its revenues come from DRAM products.

A major strategy in this regard has been the acquisition of Numonyx , which has driven a 350% growth in Micron’s NOR segment.

Table 1: Revenue Breakdown

<table> <tbody> <tr> <td> <p>million ($)</p> </td> <td> <p>2009</p> </td> <td> <p>2010</p> </td> <td> <p>2011</p> </td> </tr> <tr> <td> <p>DRAM</p> </td> <td> <p>2,882</p> </td> <td> <p>4,241</p> </td> <td> <p>3,603</p> </td> </tr> <tr> <td> <p>DDR3</p> </td> <td> <p><em>3,362</em></p> </td> <td> <p><em>1,866</em></p> </td> <td> <p><em>1,845</em></p> </td> </tr> <tr> <td> <p>DDR2</p> </td> <td> <p><em>1,057</em></p> </td> <td> <p><em>2,036</em></p> </td> <td> <p><em>879</em></p> </td> </tr> <tr> <td> <p>LPDRM</p> </td> <td> <p><em>1,009</em></p> </td> <td> <p><em>1,187</em></p> </td> <td> <p><em>879</em></p> </td> </tr> <tr> <td> <p>NAND</p> </td> <td> <p>1,873</p> </td> <td> <p>3,223</p> </td> <td> <p>3,164</p> </td> </tr> <tr> <td> <p>NOR</p> </td> <td> <p>-</p> </td> <td> <p>424</p> </td> <td> <p>1,582</p> </td> </tr> </tbody> </table>

Outlook

The DRAM market has been under the hammer for quite some time now. The falling demand and increasing capacity has been catastrophic for DRAM manufacturers and margins have literally floored. There are three catalysts I believe can slow down DRAM margin erosion.

First, the DRAM industry is consolidating, and this will be a major factor in reducing excess capacity in the market. The reduced competition would also play a major hand in improving margins. DRAM manufacturers are now more efficiency focused, and this focus on cost reduction should improve profits margin in the long run.

Second, the release of Microsoft’s (NASDAQ: MSFT) Windows 8 has been highly discounted by the entire industry. A big problem for DRAM manufacturers has been the negative growth in the PC industry, and Windows 8 can play a major role in improving PC demand. The new OS is touch based and can trigger a major refresh cycle and significantly improve DRAM demand. A lot of major PC OEMs such as Dell  and Hewlett-Packard  have triggered major refresh cycles of their entire product lines. The future of this industry lies with the success of the new ultra-books which provide functionality of both PC and tablet. 

Microsoft announced in its previous quarter that it is releasing more than a 1000 devices with Windows 8, into the market. It is facing tough competition from Google and Apple, in this industry. The company is trading at a P/e of 8.4x and offers an impressive 3.4% dividend yield.  

Finally, the demand for low-power DRAM products aimed at handheld devices will continue to remain strong throughout 2013. Windows 8 should play a significant role here as well. The touch based OS is an evolutionary step towards lighter handheld products, which should improve overall demand for low-power DRAM products. The smartphones are eating away at feature phones at an accelerated pace and this super growth will keep up the demand for DRAM products made for handhelds.

The NAND prospects are even better than the DRAM segment. As can be seen in Table 1, this segment has played a major role in rescuing Micron’s falling growth. The NAND growth has been driven by the increased focus on handheld devices. Last quarter, NAND prices improved significantly due to a combination of factors.

While I believe the demand of NAND products will remain strong throughout 2013 due to growth in smartphones and tablets, there may be margin-related headwinds due to improving supply and strong competition. A major competitor in this regard is Sandisk (NASDAQ: SNDK) which is currently trading at a P/E of 13x. If we look at the graph below, the company's revenues have begun to stabilize after a downward trajectory, confirming our thesis that demand is improving.

<img src="http://media.ycharts.com/charts/3251bddca23439633ff0026d6e4c177a.png" />

SNDK data by YCharts

 The bottom line

As I have mentioned above, there is an increased focus on operational efficiency across the entire DRAM industry. Right now, the rewards of this improvement are being offset by a rise in R&D expenses. This rise is a necessity in a tough industry which requires differentiation to stay competitive.

I believe the R&D expenses will continue to rise in the future and will have a positive impact on product mix and therefore margins. The stock is currently trading at P/E of 15x and 20% below its mean sell side target price of $9. I believe 2013 is the breakout year for Micron and on these levels the stock can give at least a 20% upside.


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