/ VALUATIONS

Micron: Consolidation and Cash Flows

There’s a lot that goes into valuing a company. I’ve valued fast-growing companies in my previous articles. Astute readers may have noticed I discounted the companies cash flows, but I didn’t explain the method behind the madness. With Micron, I’m going to touch on company and market risk with the goal that the reader can learn valuation by example.

Overview

Micron Technology manufactures and sells memory and storage solutions worldwide. Its products are used in servers and networks powering the cloud, mobile phones connecting us globally, storing both consumer and enterprise data, and powering embedded devices in our cars and smart devices.

Who Has The Power

When thinking about risk, which is a rabbit hole in the world of finance, we have to understand who the marginal investor is. The marginal investor is an investor who owns enough of the stock to affect the share price. My ten shares won’t affect the price, but Warren Buffett buying or selling will! Once we identify who the marginal investor is, we can then determine if this investor is diversified. Why does it matter if the marginal investor is diversified? With diversification, you diversify away the company-specific risk leaving behind the market risk. A diversified investor will require a lower discount than the non-diversified investor. An example best demonstrates this: If you were to put all of your eggs in one basket and buy a private company, you would demand a higher return than if you were buying an index fund. Liquidity and other factors aside, the risk is much higher owning a private business. You may have only one store where a local event such as a flood could be catastrophic to your business. Requiring a higher return for a non-diversified investor leads us to the following tenet:

A company’s discount rate, and subsequently its value, depends on who is buying the company

Now let’s get back to Micron.

Stockholder Analysis

Public ownership largely dominates the ownership of Micron. Institutions and corporations hold 95% of the common stock outstanding (CSO) when including public and other non-classified investors. Individuals and insiders control roughly 0.5% of the total shares outstanding. See below for a graphical representation of ownership.

Salesforce Total Addressable Market

Nine of the ten top holders of Micron are traditional investment managers with an emphasis on passive ownership. Appaloosa Management, LP., run by David Tepper, is the only listed activist hedge fund as a top ten owner but Appaloosa does not appear to have an activist role as of yet and has purchased on the thesis of market consolidation and rational behavior of the supply side participants.

In short, the marginal investor is well diversified.

Risk Premium

While Micron’s operations generate significant transactions in multiple currencies, it reports in USD allowing for the convenience of using the 10-year U.S. Treasury t-bond rate as a proxy for the risk-free rate of 2.79%.

The risk-free rate is the foundation of what we should charge for risk. Now that we know how much of a return we can get for something risk-free, we can now determine how much to pay for something risky. Micron breaks out both revenues and net PP&E by geographic areas giving us an equity risk premium (ERP) of 5.90% and 5.62% respectively. Using the revenue-based ERP due to the trade risk of China is shown below. The equity risk premium, which we’ll cover in more depth in a later article, is the premium investors are demanding to invest in risky stocks.

We can add the risk-free rate to the equity risk premium to determine how much we should be charging for equity risk, which said another way, is the return we expect to receive for investing in equities.

RegionRevenuesERP
China17,3575.89%
United States3,6245.09%
Taiwan2,7985.78%
Other Asia Pacific2,5596.93%
Europe2,1286.01%
Japan1,2545.89%
Other Asia Pacific6717.14%
Weighted Beta 5.91%

Once we have what we should be charging for stocks as a whole, we can get to how much we should be charging for the relative risk of our company.

For now, don’t worry about the details. Just understand that there are three components of the discount rate:

  1. The rate we can get that is risk-free
  2. What investors are charging for market risk
  3. The individual or relative risk of the business

If you’re new, this may be a bit dense. I’ll cover all of the following in depth in a future article, so for now just hang on tight!

The relative risk, or beta, is calculated assuming a fully diversified marginal investor based upon the stockholder analysis above. Using a global single business sector-based bottom-up beta, Micron has an unlevered beta of 1.29 and a levered beta of 1.43. The 5-year regression beta gives us a value of 1.63; however, sector betas are a better measure of risk for multiple reasons. Both regressions being riskier than the market beta makes sense as Micron is a cyclical commodity-based company with unpredictable revenues and profits.

On December 21, 2018, Micron was given the rating of BB+ by S&P. This rating approximates the default spread for Micron of about 1.98%.

Using the weighted market values of equity and debt including capitalizing both the operating leases and R&D, and adding in the estimated market value of equity from convertible debt, we get a cost of capital of 10.26% for Micron with the equity component having a rate of 11.39% and the after-tax cost of debt component having a rate of 3.47%

Market ValueEquityDebtCapital
Capital32,531.425,396.7337,928.15
Weight85.77%14.23%100.00%
Weighted Cost of Capital11.39%3.47%10.26%

The Industry

I believe the market misunderstands the current state of the industry. Everyone knows that the demand side for memory products has a long runway. With cars, watches, toasters, and pretty much everything under the sun becoming “smart”, the demand for memory is exploding. The challenge comes from the supply-side. When demand increases, the supply side has followed up with a mass production of memory, which eventually saturates the market, and then causes price cuts. The computer memory market has traditionally followed the pattern of commodity boom and bust cycles. What is different now is that the memory market resembles the airline industry years ago. The industry consolidated, and the actors are acting more rational. On top of this, the market expectations for Micron are terrible as shown by the value.

The Value

Not surprisingly, Micron’s revenue and margins closely follow the price of DRAM. To verify this, I ran a regression of revenue against the worldwide dram average sell price from 2007-2018 and Net PP&E giving me an r^2 of 85%. This verified my assumptions that Micron is a commodity company.

Intrinsic Valuation

Micron Valuation

Relative Valuation

Relative valuation is the equivalent of comparing other similar companies to your company to determine the price.

Running a regression of all competitors of Micron named by S&P Capital IQ for the EV/EBITDA multiple against expected growth, LTM effective tax rate, LTM ROIC in place of reinvestment, and beta used as a proxy for risk gives us an r^2 of 41%. Micron’s predicted EV/EBITDA using the regression equation is 2.56 with it currently trading at 1.5.

Both the valuation and the pricing have Micron undervalued relative to the target price between 56%-58% respectively.

Full disclosure: I purchased Micron on 1/9/2019 at $36.05 share.

leo

Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.