It has been an ugly past few months for chipmaker Micron (NASDAQ:MU). Micron stock peaked around $65 in late May 2018. Ever since, rising fears regarding weakening demand and growing supply have dominated the narrative. Several analysts have cut their ratings, estimates, and price targets on the stock.
But not all hope is lost. Famed hedge fund manager David Tepper, whose fund has raked in more than 30% annual returns since 1993, talked up Micron stock in a recent interview with CNBC, saying he’s “very, very long” Micron stock on the belief that the “demand side is going to be good for a long time.”
Micron stock traded about 5% higher on the bullish commentary.
I agree with Mr. Tepper. The demand side is going to be good for a very long time when you consider just how diverse that demand is across multiple industries with secular growth potential, like cloud data centers, AI, AR/VR, automation, smartphone — so on and so forth. The valuation on MU stock is also compelling, with the stock trading at under 4 times forward earnings. In other words, the fundamentals for Micron stock look strong.
But, historically speaking, as goes earnings, so goes Micron stock. And earnings are expected peak soon, regardless of demand, because of supply ramp. Thus, there is some real sentiment risk here to buying Micron stock.
Long story short, I don’t fault anyone for buying here. The fundamentals are strong, but I’ll wait until there’s more clarity regarding this earnings cycle before buying back into this cyclical and risky stock.
Micron’s Fundamentals Are Strong
I completely understand where Mr. Tepper is coming from.
From a pure fundamentals standpoint, MU stock looks great here. Demand for Micron’s suite of products will remain robust thanks to diverse demand across multiple nascent end-markets oozing with growth potential, like cloud data-centers, AI, AR/VR, automation and smartphones. Considering we are just entering the data era where everything is going digital, demand from these markets promises to remain robust for the foreseeable future. Thus, regardless of how much supply ramps, persistently robust demand should offset supply increases, and stabilize long-term profit growth.
Historically speaking, Micron’s peak-to-trough earnings declines last about two years and take about $4 in earnings per share off of peak earnings. According to Street estimates, earnings are expected to peak this year around $12. Thus, if this forthcoming down cycle is normal, earnings should stabilize at around $8 per share in two years. A historically-average 9 forward multiple on that implies a one-year forward price target of over $70.
This implies 60% upside from current levels.
Thus, from a pure fundamentals standpoint, the reward potential on MU stock looks immense here and now.
Earnings Erosion Creates Sentiment Risk
But, in the stock market, fundamentals aren’t the only thing investors need to pay attention to. There is a little thing called sentiment and when the fundamentals aren’t crystal clear, sentiment can be a big reason why a stock is either going up or down.
That is exactly what we have happening with Micron stock right now. The fundamentals imply that robust demand should offset supply increases, and earnings should stabilize around $8 per share in a few years. But there is an enormous lack of clarity regarding that multi-year outlook.
For starters, the market doesn’t really know if demand is due for a near-term setback or not due to trade-related tensions. The market also doesn’t know how much supply will increase in the near or medium terms, nor how much that supply growth will chop off profits. Also, the market has no idea really when this upcoming earnings down-cycle will end.
In other words, there is a lot regarding the fundamentals that the market doesn’t know. When the market doesn’t know something, it sells first and asks questions later. That is exactly what is happening with Micron stock.
This isn’t Micron’s first rodeo with earnings erosion, and this same dynamic always plays out. If you look at a long-term chart of Micron stock next to earnings, you will see that the two line up perfectly. When earnings go up, Micron stock goes up. When earnings go down, Micron stock goes down. It is a pattern that has held true since 1995, and will remain true for the foreseeable future given the lack of clarity regarding the magnitude and length of Micron’s earnings cycles.
From this perspective, now is a risky time to be buying Micron stock. Almost everyone agrees that earnings are set to erode over the next several years. The question is how much will they erode, and for how long will they erode. The market doesn’t know the answer. Thus, if history tells us anything, it is that so long as earnings are going down, Micron stock will go down too.
Bottom Line on MU Stock
I agree with Mr. Tepper that the fundamentals on Micron stock look great. But, from a sentiment standpoint, this stock tends to drop when earnings drop, regardless of valuation. Supply ramp ensures that we are due for an earnings drop starting next year.
And because no one really knows how big that earnings drop will be or how long it will last for, I think now is a risky time to being buy back into MU.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
