Why Micron Technology Inc. Is a Risky Bet

By Timothy GreenFool.com

With shares of memory chip manufacturer Micron trading for around $15 per share, down 50% so far this year, investors may be tempted to buy the stock. During fiscal 2015, which ended in the beginning of September, Micron earned $2.47 per share in net profits, putting the trailing price-to-earnings ratio at a meager value of 6.

MU data by YCharts.

Continue Reading Below

Unfortunately, things aren't as simple as they seem. Micron's profits, which have reached record levels over the past two years, are in the process of collapsing. During the fourth quarter, Micron's net income fell by nearly 60% year over year, and the company's guidance for the first quarter calls for its non-GAAP EPS to slump by between 73% and 79% year over year. While some analysts believe Micron's profits are close to bottoming out, I'm not so sure.

Falling DRAM pricesMicron manufactures both DRAM and NAND memory chips, and because both are essentially commodities, prices are determined by supply and demand. When demand outpaces supply, like it did in 2014 and the first half of 2015, Micron can record incredible profits. But when supply outpaces demand, like it did in 2012, Micron does very badly, often posting massive losses.

DXI index. Source: DRAMeXchange.

DRAM, which accounts for about two-thirds of Micron's revenue, has been falling in price during the second half of 2015. DRAMeXchange tracks an index that represents the output value of mainstream DRAM chips, and this index fell sharply from June to August of this year-- and after a brief respite, the index is falling sharply again.

Spot prices of specific DRAM variants have declined dramatically since the beginning of June. Here's how a few of them have evolved:

Data from DRAMeXchange.

Of course, the big question is where DRAM prices will go in the future. If Micron can cut its cost-per-bit of DRAM faster than the selling price declines, the company's profits may very well bottom out in the next couple of quarters. But if DRAM prices keep falling sharply, all bets are off.

Gartner expects the oversupply situation in the DRAM market to get much worse in 2016:

While weak PC demand has hurt the market for PC DRAM this year, demand for smartphone DRAM has remained strong. During the fourth quarter, while profitability in Micron's Compute Networking Business Unit, which contains PC and server DRAM, collapsed compared to the third quarter, profitability in the Mobile Business Unit mostly held up, with revenue growing slightly.

But the smartphone market is not growing anywhere near as fast as it once was. Gartner reported that worldwide smartphone unit sales rose by 13.5% year over year during the second quarter, the slowest rate in years, driven by a 4% decline in China. With DRAM manufacturers actively shifting capacity to mobile, the risk of overestimating mobile demand is very real.

New competitionOne thing Micron has going for it is industry consolidation. There are only three major DRAM manufacturers remaining, the other two being Samsung and SK Hynix, and the bull argument for Micron hinges on fewer competitors leading to less violent swings in DRAM prices. The hope is that Micron's profitability will bottom out above break-even, which would be a drastic shift from the past.

Unfortunately for Micron, new competition appears to be on the horizon. In July, it was reported that state-owned Chinese tech company Tsinghua Unigroup was preparing a $23 billion bid to acquire Micron. Regulatory issues make the deal unlikely, with Micron itself stating that the deal is not possible due to national security concerns.

According to The Wall Street Journal, Tsinghua has changed course, with plans to invest more than $12 billion in an effort to build a memory chip business in China. Most of the cash, which will be raised in a private placement, will be used to build a memory chip factory, with the rest going toward acquisitions of semiconductor companies.

While it will likely take at least a few years, and possibly longer, before the company produces any memory chips, the prospect of raising the number of major DRAM manufacturers back to four kills one of the arguments for investing in Micron.

While Micron stock looks cheap, the company is facing some pretty serious headwinds. If weakness in the DRAM market broadens in 2016, as Gartner is predicting, Micron's profitably is unlikely to bottom out anytime soon, and when it does, it's very possible the company will be in the red, depending on how far prices fall. Looking out further, the potential addition of a major Chinese competitor could essentially undo the consolidation in the DRAM industry. The bottom line: Micron is a risky investment despite its seemingly attractive valuation.

The article Why Micron Technology Inc. Is a Risky Bet originally appeared on Fool.com.

Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Gartner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.