Are Sunny Days Ahead for Micron as DRAM Prices Rise?

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Shares of Micron (NASDAQ: MU) have rallied roughly 60% this year as surging demand for memory chips caused prices to soar. As the world's third-largest DRAM maker and fourth largest NAND maker, Micron is widely regarded as the best "pure play" on memory chips.

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Investors might be skeptical about Micron's continued growth, since the stock is flirting with a multiyear high in a frothy market. However, Micron trades at just six times forward earnings estimates -- a very low valuation for a company expected to grow its non-GAAP earnings from $0.06 in 2016 to $4.72 this year.

Research firm IC Insights recently reported that DRAM prices more than doubled over the past year, and are on track to rise 40% in 2017. The firm calls the current trend "payback" against OEMs, which negotiated lower DRAM prices when demand was softer in previous years. So does IC Insights' report indicate that sunny days are ahead for Micron? Or are there hidden pitfalls which investors should watch out for? Let's take a look at the sides of this topic.

Why Micron investors should be bullish

Even before IC Insights released its report, analysts had expected Micron's revenue to rise 62% this year and another 13% next year. Micron's non-GAAP earnings are expected to climb another 32% in fiscal 2018.

Recent earnings reports from PC makers, which buy a large percentage of Micron's DRAM, also indicate that demand for PCs is warming up again. For example, HP (NYSE: HPQ) -- the largest PC vendor in the world -- reported that its Personal Systems (PC) revenue and shipments respectively rose 12% and 7% annually last quarter. Slumping desktop shipments, which fell 3%, were offset by 12% growth in notebooks.

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Many PC vendors also admitted that they were passing on high memory costs to consumers. That throttles the full growth potential of the PC market, but indicates that memory chipmakers have the upper hand against OEMs in price negotiations. If memory prices continue rising, Micron could easily beat expectations over the next few quarters.

Moreover, Micron continues to develop next-gen memory technologies with its longtime partner Intel. It's also expanded its manufacturing capabilities over the past few years by buying smaller companies like Inotera Memories, Tidal Systems, Convey Computer, and Pico Computing. Those moves could all boost its margins while widening its moat against bigger rivals like Samsung and SK Hynix.

Why Micron investors should be cautious

However, we should remember that Micron is a cyclical stock that has repeatedly punished investors who were too late to the party. During past memory cycle peaks, a chipmaker or two usually broke rank with the industry to ramp up DRAM production and gain market share.

Micron has declared that it won't boost its DRAM capacity for the foreseeable future. Instead, it plans to increase production by shrinking its die size -- which could keep it ahead of the tech curve. Samsung hasn't said much about its future plans for DRAM production.

However, SK Hynix recently stated that it will start boosting its DRAM capacity, since it was unable to meet growing market demand with technological improvements alone. Micron also warned investors that state-backed Chinese makers could eventually flood the market with cheap memory chips. The recent alleged theft of Micron's IP by employees at Taiwanese chipmaker UMC -- for use in a joint venture with a Chinese chipmaker -- also indicates that Chinese tech could catch up in the near future.

Those red flags, along with the rising prices of PCs, indicate that the run-up in memory prices could be unsustainable. If SK Hynix or Chinese chipmakers cause global DRAM supplies to rise again, the OEMs could regain the upper hand in price negotiations.

Sunny days or storm clouds?

It's easy to understand the bull thesis for Micron: the global memory chip supply tightens, prices rise, and Micron's revenue and profits soar. But I'm personally not eager to buy Micron since this looks more like a cyclical peak than a trough -- and emerging headwinds on the production front could blow the stock off course.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool recommends Intel. The Motley Fool has a disclosure policy.