Why the Market Hated Micron's Earnings

Memory chip manufacturer Micron (NASDAQ: MU) once again put up impressive numbers when it reported its fiscal second-quarter results on Thursday. Revenue soared 58%, driven by both volume and price increases for its DRAM chips, and the company's third-quarter guidance came in above analysts' expectations. Overall, it was an apparently solid report that earned the stock some analyst price-target bumps.

Yet the stock tumbled the next day: As of noon Friday, shares of Micron were down about 6.5%. What's going on? There are two likely reasons why the market didn't applaud Micron's report.

NAND trouble

While Micron's DRAM business is booming, its NAND business is more mixed. NAND bit volume increased during fiscal Q2, both compared to Q1 and the prior-year period. But the NAND average selling price slumped. Compared to Q1, Micron saw a mid-teens percentage decline in NAND per-bit pricing. That led to a two percentage-point drop in adjusted gross margin in the NAND business.

The storage segment, comprised of solid state drives and other storage products, saw revenue slump by 9.4% compared to Q1, with operating margin falling nine percentage points to 20%. Both revenue and operating margin were up year over year, however.

One thing we don't know is how Micron's per-bit costs for NAND changed during the second quarter. The company stopped disclosing that key metric in its first quarter report, so investors were left in the dark.

These NAND issues led at least one analyst to downgrade Micron stock on Friday. An analyst at Citi dropped his rating from buy to neutral, concerned that the NAND market could be "rolling over." Because NAND pricing is based primarily on supply and demand, oversupply can lead to steep declines in price. The concern is that NAND pricing will continue to deteriorate going forward.

Increased investments

Demand and pricing for DRAM, which represented 71% of Micron's revenue in Q2, remains strong. Volumes rose by a mid-single-digit percentage compared to the first quarter, and average selling price jumped by a low double-digit percentage.

But Micron may have spooked investors with word about its plans to expand its production facilities. During the earnings call, the company disclosed that its fiscal 2018 capital expenditures would be at the upper end of its previous guidance range, thanks to the build-out of additional clean room spaces in Singapore and Japan. The Japan project will come online for production at the beginning of 2019, with the Singapore project following toward the end of the year.

As with NAND pricing, DRAM pricing is largely determined by supply and demand. When demand growth is outpacing supply growth, high prices and fat profits follow. When the opposite is true, prices can plunge and take the bottom line down with them.

The risk for Micron is that it's overestimating what demand will be. A miscalculation on its part -- or on the part of Samsung, which is also reportedly building out new production space -- is all it will take to torpedo the current healthy market environment.

This is exactly what you'd expect to happen in a commodity market. A period of surging prices encourages market participants to increase production to take advantage of that demand and maintain market share. That increased production, coming online years later, brings supply and demand closer into balance. But it can also go too far, creating oversupply and pushing down prices dramatically.

There's no telling exactly when the market for DRAM chips will normalize. In fact, demand could very well be strong enough to offset these planned production increases. But investors are clearly concerned that the seeds of the next downturn are being planted.

One important thing about Micron's outlook

Micron provides a general outlook for both the NAND and DRAM markets in all its quarterly earnings presentations. This time around, the company said it expects a "more balanced industry dynamic" for NAND in 2018, and a "healthy demand environment with secular growth drivers" for DRAM.

Investors should take that outlook with a grain of salt, though, because forecasting the memory chip markets is mostly a guessing game. Here's an example: In Micron's earnings presentation for Q4 2015, which ended in August of that year, the company said this: "We expect industry supply and demand for both DRAM and NAND to be relatively balanced in 2016."

What happened in 2016? DRAM average selling prices plunged 35%, NAND average selling prices fell 20%, and Micron reported a net loss for the fiscal year. Micron's forecasts tend to be accurate until they're not.

There's no disputing it: Micron's Q2 results were spectacular. But its performance almost certainly won't remain spectacular forever.

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Timothy Green 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.