Summary
- The company has transformed its balance sheet from one of net leverage to net cash of $4.9 billion as of the latest quarter.
- I explain why the 13% earnings yield is deceiving - investors should focus on the free cash flow yield.
- Micron is frequently seen as a value stock, but the free cash flow yield does not validate that sentiment.
- Multiple expansion is the most important driver of forward returns and will dictate where this stock ends up in 5 years.
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Micron $Micron Technology(MU)$ is a semiconductor stock which has not kept up with the rest of the pack.
While other names like Nvidia (NVDA) or AMD (AMD) have returned multiples of their stock prices over the past few years, MU finds itself trading barely higher than where it traded four years ago. The stock has struggled with achieving multiple expansion due to the cyclicality of its business, as investors are constantly wondering when earnings will peak.
The key to upside over the next five years is if the company can rewrite its story to one of solid cash flows over cross-cycle periods. Trading at less than 7.5x forward earnings, the current valuation appears to reward shareholders willing to make that leap of faith. A closer look at free cash flow reveals that it isn't such an easy decision to buy the stock.MU Stock PriceAfter falling 36% to start the year, MU finds itself trading around $72 per share.
Data by YCharts
That stock price places it within 20% of where it traded four years ago, marking stunning underperformance for a company that has materially improved its balance sheet and cash flow structure.MU Stock Key MetricsMU derives the majority of its revenue through sales of DRAM and NAND chips. MU saw solid growth in each of these segments in the latest quarter.Micron FY22 Q2 PresentationIn the quarter, MU generated $3.6 billion of cash from operations and spent $2.6 billion on capital expenditures, yielding free cash flow of $1.03 billion. The company spent $408 million of that on share repurchases and initiated a small $0.10 per share dividend.
Micron FY22 Q2 PresentationThe company ended the quarter with $4.9 billion of net cash and $14.4 billion of liquidity, representing the strongest balance sheet position in years. Looking forward, MU expects around $8.7 billion of revenue representing 17% year over year growth.
Micron FY22 Q2 PresentationWhat Are Micron Technology Catalysts To Watch For?There are several potential catalysts on the horizon for MU stock. The most important is if the memory business can evolve from its cyclical history to become more of a secular growth story. We might be witnessing this transformation as the company sells into attractive end markets like data centers, 5G, and automotive industries.
Micron FY22 Q2 PresentationMU has worked hard to reshape its story. Over the last several years, MU has transformed its balance sheet from one of net leverage to one of net cash.
2021 Capital Allocation PresentationThe strong balance sheet position and improved cash flow structure have enabled the company to commit to returning 50% of cross cycle free cash flow to shareholders through share repurchases and dividends.
2021 Capital Allocation PresentationMU is taking the right steps in executing the shift in stock sentiment and I expect the stock to reap the rewards over time, though it isn't clear if now is that time.Where Will Micron Technology Stock Be In 5 Years?Wall Street consensus estimates call for earnings to continue growing before peaking in 2024.
Seeking AlphaYet the most important element of the stock outlook is arguably not earnings forecasts but instead stock sentiment. The cyclicality of MU’s business has historically kept many investors away, but MU has shown its ability to increase cash flow generation on a 4-year moving average.
2021 Capital Allocation PresentationWhile earnings may fluctuate year to year, MU has shown that multi-year cash flows are increasing over time. Will Wall Street buy the narrative?Is MU Stock A Buy, Sell, or Hold?Historically, buying MU stock has been about timing the peaks and troughs. At first glance, it may seem like the stock is a great deal with the PE ratio hovering in the high single digits.
Data by YCharts
But cyclical stocks tend to have significant volatility in underlying earnings, and MU is no different as seen below:
Data by YCharts
One easy way to analyze valuation while adjusting for cyclicality is to look at the price to sales multiple - by focusing on sales, the multiple is not so heavily impacted by the effect of operating leverage. We can see below that MU is actually trading near historical highs in terms of valuation.
Data by YCharts
Yet one could make the argument that MU stock should trade at even higher multiples from here based on the net cash balance sheet and shareholder-friendly capital allocation policies. I think it is too early to assume that MU will start trading at secular-growth-type multiples, but perhaps some may believe that 7.5x earnings is too conservative. It is possible that overall demand for memory chips can soar, propelled by the secular growth tailwinds of sectors like data centers, 5G, and the general internet of things. It is possible that the increase in demand can eventually offset the historic cyclicality of the memory chip market. If that were to occur, then I could see MU trading up to 10x-12x earnings, representing up to 70% multiple expansion potential.
I hesitate to assign a higher earnings multiple because I expect some doubts to linger even over the medium term.Let’s now explain why that kind of thinking may be flawed. MU has historically reinvested cash from operations in capital expenditures, and has not been able to materially grow free cash flow over the long term.
Data by YCharts
Based on MU’s own numbers, the company generates just over $4 billion of 4-year free cash flow. On an annualized basis, that represents a free cash flow yield of just 2.4% - far lower than the current 13% earnings yield. This distinction is important because dividends and share repurchases are paid out of free cash flow, not earnings.
The company has a strong net cash balance sheet so it does not need to direct free cash flow towards debt paydown, but with the stock trading at an implied 2.4% free cash flow yield, does it really matter? MU is frequently seen as a value stock, but the current shareholder yield does not validate that sentiment. Above, I made the argument that the multiple could expand to 12x earnings if the company can prove it is benefitting from some secular growth tailwinds.
However, our analysis of free cash flows shows that the company might actually need such a shift to simply justify the current stock price. The company has grown 4-year free cash flow by around 500% over the past seven years, but will need to continue growing free cash flow moving forward. Even if the company grows free cash flow by another 200%, the free cash flow yield will still stand at around 7.2% - still far lower than the implied 13% earnings yield.
The current valuation is one more representative of a growth stock, even though MU is frequently considered to be a value stock.That is what I believe to be the problem at play here: whereas the stock appears cheap on the basis of earnings, the stock is anything but cheap on the basis of free cash flow, and we are already using the elevated free cash flow numbers of recent years.
Sure, a shift in sentiment might alone be enough to spur multiple expansion, but is that so likely considering the low free cash flow yield? In my view, multiple expansion will occur primarily as the company ramps up dividends and share repurchases, as that would be the most obvious way to rid itself of the cyclical stock status. Yet those dividends and share repurchases won’t be so meaningful until the free cash flow yield increases, and that might not be so easy to accomplish - we just saw above that a 200% increase in free cash flow isn’t quite enough to reconcile free cash flow with earnings.
Over the next five years, I view it to be unlikely that the stock will be able to achieve the important sentiment shift - or at the very least, the current 2.4% free cash flow yield does not compensate shareholders enough to take the risk. I rate shares a hold and caution investors from buying into the stock on the basis of the earnings yield.
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