Micron Technology’s (NASDAQ:MU) previous earnings beat was a lot easier to predict. Most investors feel – and reason – that MU will most likely report another earnings beat. But I hesitate to conclude that this will result in a share price appreciation. I believe that MU will report an earnings beat.
But I do not expect share prices to move materially as I believe that this is already priced in. To illustrate my conviction, I model the earnings beat and extrapolate the implied valuation using a discounted cash flow model. The logic is straight forward. If the implied valuation as a result of the earnings beat is higher than pre earnings, the units should move up. If the implied valuation is lower than or very close to the current stock price, the units should adjust downward to reflect lowered expectations.
First, I need to get some sort of grip on what the market is expecting. The point here is to find out whether MU is cheap based on a discounted cash flow analysis. The rational here is that the earnings report will imply how cheap or expensive Mu is relative to market expectations.
For those who are wondering, there is little point in using metrics like PE. The company is too cyclical and the PE does not represent the true value of the cash flows. This is regardless of whether investors are using trailing or forward PE. I’d even go so far as to argue that a PE is usually not that very useful. I digress.
I always like to start with a company’s cost of capital or WACC which is made up of equity and debt.
Let’s start by rearranging Micron’s debt load which looks like this in the sec-filing:
Micron does not seem to have a high average cost of debt at first sight. Of course, we can check:
Source: Author’s excel sheet
Considering that most of this is long-term debt, the cost of debt is not high at all. To get the cost of equity, I’ll be using a risk free rate of 2.20% and a market risk premium of 6.00 multiplied by a beta of 1.77. This results in a WACC of 10.44%.
Source: Author’s excel sheet
As a discount rate, I’ll be using 10%.
I’m always a bit hesitant to model these highly cyclical companies that are growing at incredible paces. Considering that MU’s 1Q17 result represented a 58% growth from that same quarter last year, it is safe to say that MU can be defined as such a company. By contrast, the market seems to be extremely relaxed. It takes a collection of quite buoyant views to justify the current share price of $36. These assumptions mostly have to do with the generated free cash flow and revenue growth rate.
We need to keep in mind that H2 is seasonally much stronger so the gross margin will likely be higher in H2. In any case, if I model a FY2017 gross margin of 40%, I get a free cash flow margin of 8.5%. For perspective, the company’s 1Q17 free cash flow margin was 5.19%. Secondly, I’ll model a 26% free cash flow margin in FY2018, reflecting higher ASPs and the cyclical acceleration. I assume that this cyclicality continues until 2021 albeit in a more moderate acceleration. The cyclicality looks like this:
Source: author’s excel sheet
Let me explain the year 2022. Obviously, cyclicality has to end sometime. By looking at MU’s historic cyclicality, I figured out an appropriate bottom year. Consider MU’s free cash flow margin of the last 10 years:
In the last 10 years, MU has reported a free cash flow margin of negative 20% or more in at least three of those years. I do not consider it extreme at all to model just one painful year in 10 years’ time. Also consider that I model a 26% free cash flow increase so as to be fair to both sides.
I combine these margin assumptions with the following revenue assumptions:
1) The company increases its revenue by 73% in the upcoming year. I do consider this assumption to be aggressive. The company would need to earn an additional $16.8 billion in the next three quarters to do this. This will only be possible if the company reports at the high end of its guidance of $5.6 billion in 2Q17 and subsequently reports at least $5.6 billion in revenue per quarter for the next two quarters.
2) The company grows its revenue by a CAGR of 30% until 2020.
3) Revenue remains flat in 2021, declines by 22% in 2022 and 22% 2023
4) Revenue grows by 30% in 2025 and 2026
Most readers will probably have a problem with my two decline years. I understand that 22% might seem excessive, however, it is well within historical values. The company’s revenue declined in 22% in 2016 and by 19% in 2009.
The following results in a price of roughly $36/unit. Put differently, the company would have to deliver on the high end of its revenue guidance as well as report a gross margin of at least 40% in order to not disappoint the market. That begs the question, do I think they will?
Posing that question forces us to estimate the company’s upcoming earnings report. Wall Street is estimating $5.4 billion in revenue and $1.50 in earnings per share. I believe that the company will indeed beat Wall Street’s revenue guidance of $5.4 billion. The company should at least be able to report $5.45- $5.5 billion in revenue. I remain skeptical as to whether the company can actually produce $5.6 billion in revenue. I do believe that the gross margin is easily attainable. After going down the P&L line I conclude that the company will report an EPS of $1.58 a share. This is based on a gross margin of 46% and a tax rate of roughly 5%.
While I believe that MU will most likely report an earnings beat, I hesitate to conclude that this will result in meaningful share price appreciation if units are still trading around $36. I believe that the probability favors the downside and investors should consider protecting themselves with puts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.