Better Buy: Micron Technology vs. Cypress Semiconductor
Chip stocks have made a big comeback this year after a forgettable end to 2018. The PHLX Semiconductor Sector index regained nearly a quarter of its value in 2019 after dipping toward the end of last year, so it is not surprising to see that its components Micron Technology (NASDAQ: MU) and Cypress Semiconductor (NASDAQ: CY) have also been performing well.
However, the near-term outlook for both Micron and Cypress isn't favorable right now because the companies are facing headwinds in their respective end markets. While an oversupply in the memory industry is troubling Micron, Cypress has warned that weak semiconductor demand could derail its growth this year.
In such a scenario, which one of the two stocks should you be betting on?
The case against Micron
Micron Technology is the world's third-largest maker of dynamic random access memory (DRAM), after Samsung and SK Hynix. The problem with Micron is that the DRAM market is a cyclical one and is prone to huge swings in prices depending on supply and demand.
The current situation in the DRAM market does not favor Micron. The memory market is in the midst of a bust cycle, and that's clearly impacting the chipmaker's financial performance. Micron's revenue dropped 20.5% annually during the second quarter of fiscal 2019, while adjusted earnings crashed to $1.71 per share from $2.82.
Its current-quarter guidance isn't pretty, either. Micron forecasts $0.85 in adjusted earnings per share on revenue of $4.8 billion, which would be a massive drop over the prior-year period's revenue of $7.8 billion and adjusted EPS of $3.15. But investors are still upbeat, as Micron expects an uptick in DRAM demand during the fiscal third and fourth quarters.
Even though Micron management expects DRAM demand to improve sequentially in the second half of the fiscal year, it has raised enough red flags that clearly indicate why Micron is a stock best avoided for now.
Weak near-term demand and low visibility mean that it is difficult to gauge when a turnaround is actually going to happen. Also, Micron's guidance proves that it needs much more than just an improvement in demand to deliver results on the ground. The fact that Micron is idling DRAM capacity on account of weak end-market demand doesn't exactly inspire confidence.
As such, it wouldn't be surprising to see Micron's rally come to an abrupt end in the coming months if the DRAM market's conditions don't improve substantially. This is because its DRAM revenue was down 28% year over year and 30% sequentially in the second quarter on the back of a 20% sequential decline in DRAM prices.
The bad news is that DRAM prices aren't expected to recover anytime soon. DRAMeXchange estimates that DRAM prices could drop in the range of 15% to 20% this year as demand from key end markets such as cloud computing, personal computers, and data centers remains weak. This could spell trouble for Micron because DRAM supplied 64% of its total revenue last quarter.
The case for Cypress
Cypress Semiconductor delivered impressive growth last year, but it is in a spot of bother in 2019 thanks to weak semiconductor demand. The company's first-quarter 2019 outlook wasn't up to expectations. Cypress expects $535 million in revenue at the midpoint of its guidance range, well below the year-ago period's revenue of $582.2 million.
The EPS guidance of $0.24 per share compares unfavorably with the year-ago period's EPS of $0.33. In fact, Cypress' top and bottom lines are expected to take a big tumble in 2019. However, investors remain upbeat about the company because of its focus on opportunities that could help it grow at a faster pace than the overall semiconductor space.
For instance, Cypress is experiencing impressive traction in the automotive market, which now supplies 36% of its revenue. This business was up 13% annually last quarter and increased 11% in the previous year. Demand for chips will keep increasing in the double digits over the coming few years thanks to the deployment of connectivity applications and features such as advanced driver assistance systems (ADAS).
Cypress already has relationships with leading component makers such as Continental and Bosch that are using its chips to power automotive applications. What's more, Cypress' design wins increased 24% last year, of which 37% were for the company's new chips. These design wins should eventually translate into growth when they are deployed.
In fact, Cypress claims to have $1.2 billion in design wins for one of its automotive chips, which should ensure the long-term growth of this business. In addition, Cypress's margins have improved significantly thanks to its strategy of targeting fast-growing semiconductor niches.
The company has recorded a gross margin improvement to the tune of nearly 11 percentage points since 2016, exiting the fourth quarter of 2018 with a 47.8% gross margin. Cypress expects to achieve a 50% gross margin level in the future, which seems possible once the near-term headwinds clear out.
The verdict
Unlike Micron, Cypress isn't plying its trade in a cyclical industry. Sales of its chips should pick up the pace in the future because of its large design win pipeline. Micron, on the other hand, needs a boost from the cyclical memory industry in order to make a comeback, which looks unlikely at this point, given the current oversupply.
Finally, Cypress will reward investors with a dividend yield of 2.86% as they wait for an improvement in chip demand. Meanwhile, Micron doesn't pay a dividend. As such, investors would be better off with an investment in Cypress Semiconductor because of the catalysts it is positioning itself to benefit from and its dividend, while Micron looks like a risky bet given the cyclical nature of its business.
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Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool recommends Cypress Semiconductor. The Motley Fool has a disclosure policy.