Understanding Micron's Inventory Problem

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On Dec. 18, memory specialist Micron (NASDAQ: MU) announced results for the first quarter of its fiscal 2019, and issued guidance for the second quarter of fiscal 2019. While the first-quarter results were largely in line with expectations, the company's guidance for the second quarter of fiscal 2019 fell substantially short of analyst estimates.

During the conference call that followed the memory maker's earnings release, CEO Sanjay Mehrotra said that the company "delivered strong profitability despite revenue headwinds from the inventory adjustments at several customers, and industrywide CPU shortages."

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Let's take a closer look at what management had to say about those "inventory adjustments," as it's important for current and prospective investors in Micron stock to have a handle on what's going on here.

What's the problem?

Mehrotra said that "[due] to a lengthy period of rising DRAM prices, we believe some of our customers had decided to carry higher-than-normal inventory levels, and as DRAM supply caught up with demand, these customers are bringing down their inventory levels."

The idea here is straightforward. In a situation where prices of a commodity seem to be rising without pause, it could make sense for large consumers of that commodity -- in this case DRAM -- to buy as much as they can get their hands on, in a bid to optimize their own profitability.

Now that DRAM pricing has peaked and is on the way down, those customers probably don't feel the urge to stockpile more DRAM, since they're less anxious that if they don't buy now they'll have to pay more later. I'd imagine that it's quite the opposite -- if prices on a commodity are falling, the thinking might very well be: "We might be able to get it cheaper at a later date."

DRAM sales made up 68% of the company's revenue last quarter.

It's not just DRAM, either. Micron also generates a significant amount of its revenue from sales of NAND flash -- 28% came from trade NAND flash last quarter. While Mehrotra said that "while the inventory levels [of NAND flash] at customers are in better shape, NAND suppliers appear to have elevated levels of inventory."

The executive explained that the "transition from planar to 3D NAND in the industry, and the successful ramp of 64-layer [NAND] across the NAND manufacturers ... resulted in oversupply in the market over the last several quarters."

What happens next?

Mehrotra told investors that the company's "assessment is that inventory adjustments will take [a] couple of quarters for it to be corrected, for it to work through the system entirely."

To that end, Mehrotra said that barring "weaker macroeconomic conditions, we expect our DRAM bit demand to grow sequentially in our fiscal third quarter." The executive also claimed that "as we enter the second half of calendar 2019, we expect a healthier demand environment alongside an improved industry supply picture, which should contribute to improved financial performance."

As far as NAND flash goes, Mehrotra claimed that "even after taking into account recently publicly announced NAND capex [capital expenditure] reductions for calendar 2019, our assessment is that the NAND industry supply growth will exceed industry demand growth in the coming calendar year."

When supply growth outpaces demand growth, that leads to pricing pressure, ultimately negatively impacting gross margin. In response, Micron is "lowering 2019 bit growth and further reducing fiscal 2019 NAND capex."

For what it's worth, the executive did say that the company expects NAND demand will "accelerate in the second half of the calendar year, as demand elasticity kicks in for the mobile, enterprise, and client markets."

What that means: With NAND flash pricing coming down, customers might be willing to buy more of it.

At any rate, it's looking like Micron and its investors will have to deal with a couple of rough quarters before things get better.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.