We See Near-Term Weakness but Longer-Term Value in Micron

NAND More Promising for Future Growth Micron is a significant supplier and manufacturer of memory used in a plethora of electronic devices ranging from personal computers to smartphones. The firm had a market share of 20% of total memory shipments in 2014, per Gartner. In fiscal 2015, DRAM accounted for roughly 65% of total revenue, with NAND making up the remainder. We believe operating in the highly competitive and cyclical memory space will limit Micron's long-term profitability.

DRAM, or dynamic random access memory, provides high-speed data storage and retrieval while a device is in operation. A NAND flash product is electrically rewritable, nonvolatile memory that retains content when power is turned off. This characteristic makes it ideal for mass-storage uses, specifically for solid state drives that have begun displacing traditional hard disk drives. We view NAND as a more promising avenue for future growth, with SSDs poised to be used in the majority of PCs and data centers.

There tends to be little to no product differentiation in memory storage, with average selling prices normally tracking downward over time. This ultimately leads to major price competition between industry leader Samsung and second-tier firms such as Micron and Hynix. The smaller competitors generally establish joint ventures, such as Micron's with Intel, in an attempt to come up with superior memory solutions. Through this partnership, Micron has developed next-generation 3D NAND as well as the upcoming 3D XPoint technology, which we believe will allow the firm to weather economic and cyclical downturns.

Commodification Hampers Profitability We believe Micron does not have an economic moat. Memory chips, even the latest generation (3D NAND), tend to quickly become commodified in this highly competitive and cyclical space. As a result, transient product differentiation hampers long-term profitability for all parties involved. Also, the delicate balance between supply and demand remains a formidable concern, with bouts of oversupply crippling margins and times of undersupply leading to overexpansion. We think the consolidation that has taken place in recent years should encourage the remaining players to behave rationally with respect to future capacity additions. However, it only takes one superfluous fabrication plant coming on line to push the market into oversupply.

Samsung, which accounts for about 35% of total memory shipments, including both DRAM and NAND, is the largest player and holds considerable clout among smaller peers such as Micron, Hynix, Toshiba, and SanDisk SNDK. In order to develop more advanced products, these smaller competitors frequently establish joint ventures to gain the required technical knowledge. For example, Intel and Micron have partnered to design, develop, and manufacture NAND flash and share the output in proportion to each party's investment. While we think this joint venture combined with Micron's own intellectual property will allow it to weather the cyclical nature of the memory market, the combination of the aforementioned industry dynamics prevents us from assigning Micron an economic moat.

Competition and Cyclicality Make a Risky Combo As a subset of the broader semiconductor industry, the memory space is inherently cyclical. The commodified DRAM and NAND markets create volatile pricing along with supply and demand imbalances that create challenging periods for firms such as Micron. Another major risk is the strong competition from the likes of Samsung, Hynix, SanDisk, and Toshiba, which may be able to develop technologically superior memory solutions than those of Micron, leading to stretches of underperformance where the latter is unable to adequately invest to bridge product portfolio gaps. After taking into account these factors, we assign a very high fair value uncertainty rating to Micron.

Micron carried $7.6 billion in total debt, partially offset by $4.0 billion in cash and equivalents, as of February 2016, while operating cash flow in fiscal 2015 was $5.2 billion. The recent rise in debt is mainly in support of the firm's manufacturing capacity expansion in its Singapore facilities and the Inotera acquisition. We believe that the company generates ample cash flow to meet its increased interest expense obligations, but we'd like to see a greater cash cushion to navigate the cyclical peaks and troughs to which the memory industry is susceptible while maintaining an adequate research and development budget to remain competitive.