People claim that Micron is a risky proposition since the memory industries experience constant cycles. There is another opinion, however, that AI has changed all that and so the previous cycles are irrelevant. Yet both of these arguments avoid the difficult job of assessing the current contracts.
We think that Micron might become more predictable, but it will not derive unlimited benefits from AI spending. Although customers may be willing to pay for a reliable supply, they usually manage to secure some of Micron’s future profits as well. This kind of trade-off must be carefully evaluated.
It is important to make this distinction since Micron is achieving exceptional results. In the third quarter its revenue was $41.46 billion and its GAAP gross margin was 84.6%. The company anticipates a margin of about 86% in the fourth quarter. Although these figures are impressive, they do not indicate what margins Micron can achieve over the course of a full investment cycle.
The shareholder trade inside a supply agreement
Micron has announced 16 strategic agreements with customers, these involving take-or-pay commitments and in the case of the largest ones both minimum and maximum prices have been set. Micron Q3 Form 10-Q, page 27.
The agreements include around 20 per cent of the DRAM volume and one third of the NAND volume during the period in question. Although management aims to eventually achieve coverage of half or more of revenue, this is a separate objective for the future. Negotiations regarding the premiums for new products are still ongoing. Micron have prepared comments, on pages 3 to 4.
When a supplier enters into this type of contract it is making a real economic trade-off; the price floor serves to guard against a fall in market prices and the ceiling ensures that customers receive some of the benefits if a shortage occurs. The two features should be considered together, not one at a time.
Picture a memory contract having a minimum price of 70 and a maximum price of 100; if the market price falls to 50, the floor ensures a protection of 20 in value, and if the price rises to 140, the ceiling means that the customer retains 40 of what could have been earned in revenue. These figures are merely example values and not the actual contract prices set by Micron. The example illustrates that the value of a contract is determined by the future prices, the amount committed, and the cost of delivering the product.
The agreement can still be very favourable to shareholders even if there are these compromises, since by preventing a large cash shortfall the company will be able to avoid the need for expensive borrowing, cutting back on investments, or having to dilute its shares. It is valuable to have predictable income when it comes to factories that require large investments before demand has been established.
The valuation should take this trade-off into account. It would be wrong for investors to grant the company extra value in order to provide it with protection against losses and at the same time assume that it will receive full shortage pricing on those sales; that would amount to double-counting the benefits.
A price floor leaves production costs exposed.
The next point is the amount of profit that is left when prices are at the floor.
In the case described, when the floor price is 70 and the unit cost is 20, the gross profit is 50; if the unit cost rises to 35, the gross profit falls to 35, representing a 30% decrease, even though the customer continues to pay the protected price. Committed volume is only of any benefit if each additional unit still provides a satisfactory return after the cost of supplying it has been taken into account.
That is the reason why the contract should be of the same length as the factory and product plans. What products are covered? How does the agreement deal with changes in the product specifications? Who is responsible if there is a difficult transition? A supplier may have considerable rights regarding customer orders but can still encounter major manufacturing risks.
It by no means implies that all new products will have a negative effect on margins; rather, it points out the difference between a sales contract and a forecast of cash flow for shareholders. Higher yields, an improved product mix, and agreed-upon premiums could more than make up for the increased costs. It is important that analysts make these assumptions clear.
The cash balance needs an ownership test.
Micron has projected customer deposits and related commitments totaling $22 billion, of which about $18 billion consists of cash deposits. Management stated that deposit flows constitute financing cash flows, which are excluded from free cash flow and are returned later under the agreements. These are projected inflows and should not be deducted wholesale from the previous quarter’s cash balance. These comments appear on page 7 of Micron’s remarks.
The fact is that this financing is valuable since it reduces the requirement for external capital in order to grow; the true advantage lies in the terms of the funding and the returns obtained during the time the money is held.
That is not equivalent to customers providing shareholders with a permanent cash payment. If you include the entire deposit in the equity value without taking into account the obligation to return it, you inflate the benefit. Conversely, viewing these deposits as ordinary and costly debt overlooks the potential value of customer financing.
You need to consider both receipts and repayments at the same time, match them up with the balance sheet, and make sure that the same benefit is not included in both the net cash flows and the future cash flows. Greater liquidity does not necessarily mean greater wealth for shareholders.
The margin evidence extends beyond HBM.
A further interesting point in the results is that the gross margin of Micron’s Mobile and Client business was 87 per cent, as compared with 83 per cent for Cloud Memory. Since these businesses are not direct product comparisons, this does not demonstrate that regular memory is more profitable than HBM. It does, however, indicate that high profits are not confined to the AI sector.
We believe investors should consider the profit from unique products and the profit from scarcity in the wider memory market; even if profits from unique products remain strong, those from scarcity may decline.
A likely result—which is frequently overlooked in discussions that present only two options—is that demand for HBM remains strong, Micron’s strategic position improves, but a portion of the extra profits in the other areas disappears. Although the company succeeds on the technology front, its earnings may not reach the highest levels seen previously.
The other side of the argument is also possible. Contracts and improved products could keep earnings higher than in previous cycles for longer than history suggests. Any strong bearish argument should account for this possibility.
Value the protected and exposed cash flows separately.
We would carry out the assessment in three stages. In the first place, we would estimate the cash flow from the committed volumes at various contract prices, taking into account the cost of delivery. Secondly, we would examine how the business performs when prices and usage move outside the scope of the protections. Thirdly, we would model future products and new contracts by making clear assumptions regarding bargaining power.
The only thing this method does is provide a forecast, not assert that the factory can in fact be divided into three separate assets. The shared capacity, costs, and investments still have to be taken into account at the company level.
In each case the important question is this: how much cash will the shareholders receive after the company has paid for the technology, increased its capacity, and met its financing requirements?
The bullish case would be stronger if disclosures showed clear cash returns at the contract floors, if premiums from new products covered the additional costs, and if growth was achieved without reducing expected returns to investors. Conversely, the case would weaken if investment commitments increased while profits from protected sales declined, or if the unprotected portion of the business contracted sharply.
We believe our conclusion goes beyond merely forecasting a repeat of the old cycle. Although Micron may merit recognition for having altered its risk profile, the return investors receive should still be supported by the cash flows and upside left after customers obtain protection.
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