Manufacturers of PCs are having a tough time – and their troubles are spilling over into the market as a whole. When Dell’s first-quarter results fell short of analysts’ forecasts last month and the company went on to guide expectations lower as well, citing weakness in consumer demand for PCs; that news contributed to a slump in stock prices as whole. It also delivered a blow to the stocks of companies whose business revolves around supplying PC manufacturers with components, including Micron Technology (MU.O), one of the biggest suppliers of DRAM (Dynamic Random Access Memory). The company’s revenues and earnings have been falling for the last two years, part of a boom and bust cycle that has become the norm for this industry in the last few decades; now, with the new Windows 8 release, the question becomes whether Micron’s earnings prospects are about to improve? The answer to that question is a resounding “no”, according to the StarMine Earnings Quality (EQ) model. With a score of 15, it seems as though Micron’s current earnings may not be coming from sustainable sources, suggesting that it might be wise to heed the company’s own guidance.
StarMine uses computer-driven models to analyze the financial statements of thousands of publicly-traded companies, and calculates a proprietary StarMine Earnings Quality (EQ) scores for each of those businesses. Those companies recording the lowest StarMine EQ scores are the least likely to be able to sustain their past earnings track record. (For a more detailed explanation of this model, please refer to this recent article about the earnings quality of American Express.) This examination of Micron’s earnings is the next in a series of articles looking at the earnings quality of companies across North America that rank either especially low or high by this quantitative measure.
Whenever a company’s margins flag, it’s typically an indicator that it is suffering from underlying problems that will dampen growth in its bottom line. The chart below shows three key indicators of margins for Micron on a quarterly basis: gross margin (represented by the red line), operating margin (the green line) and net margin (the blue line). All three have been declining in the last two years. While only two years (eight quarters) ago, Micron’s gross margin was higher than the industry median, it now stands at 42%, more than 10 percentage points below that median. Micron’s CEO, Mark Durcan, CEO described its second quarter as being “obviously a weaker environment for pricing than we would have liked” during the earnings conference call. (You can access the full transcript of the conference call at Thomson Reuters StreetEvents). That problematic pricing environment has been a major reason that Micron has seen its margins fall; year over year, its inventory levels (measured on a quarterly level) have climbed over the last six quarters, while its competitors have seen similar inventory buildups. To the extent these growing inventories are a problem for margins for the industry, Micron and its rivals are part of the trouble. As recently as six months ago, Micron invested nearly $900 million in expanding its own capacity – the highest such level of spending it had undertaken in five years. Since then, it has scaled back its capital spending to only $392 million in the quarter ended February 2012. Nor have its peers been holding back from spending; indeed, industry-wide capacity build-ups have contributed to the boom-and-bust cycles not only in semiconductors in general, but specifically among DRAM producers like Micron. When times are good, they sow the seeds of their own downfall by over expanding.
The weak pricing environment created by the oversupply is a large reason for the falling margins, and Micron’s margins are falling further than those of its peers. In the last reported quarter, which wrapped up at the end of February, the margin for the trailing four-quarter period turned negative: -2.2%. Meanwhile, the industry margin was a much more impressive 13.1%. Micron also reported a negative gross margin (-6.3%) for the quarter; the industry median was 10.1%.
Source: Thomson ONE / StarMine
At most companies, the chart below would certainly be a cause for concern and even alarm among the occupants of corner offices. As you can see, Micron’s net income has been falling steadily for the last eight quarters, and the company reported a loss of $282 million in the February quarter, thanks in part to declining revenues in the last seven quarters.
Source: Thomson ONE / StarMine
To be sure, it’s not all gloom and doom. Micron is betting that investing in NAND drives — a new kind of high-capacity, high-speed and solid-state drives gaining prominence — will reap healthy returns in coming months; a recent contract under whose terms Intel will acquire a fixed number of NAND flash products annually may help boost Micron’s earnings in the coming quarters. Sales of NAND products accounted for 46% of the company’s sales in the second quarter of 2012, while DRAM products made up only 36%. That’s an almost direct inversion of the same period a year earlier, when DRAM sales made up 42% of revenue while NAND accounted for only 36%. As more products shift to NAND rather than DRAM, that may benefit Micron, as the NAND drives cost less to produce.
However, even NAND drives have come under pricing pressure in the last year; Ron Foster, Micron’s chief operating officer, noted a slight decrease in these margins during the second quarter that could be a worrying trend if it continues.
Regardless of what lies ahead in the more distant future, however, Micron’s StarMine EQ score of 15 of today indicates that the company’s earnings currently aren’t coming from sustainable sources, and may remain weak in the coming quarters. Even a successful launch of the new Windows 8 platform and a pickup in PC sales may not be enough to provide a big short-term boost to profits.
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