It's a classic conundrum. What do you do with a well-run company in a very tough industry? Do you focus more on the company's solid balance sheet and growth opportunities, or focus on the key issues beyond the company's control?
That's been the biggest challenge facing investors in Micron Technology (NYSE: MU).
This past September, I laid out why I think this company is poised for a great future. And for a while there, the broader investment community was in agreement.
The stock's rebound began in December after a favorable legal verdict, which I discussed in this article.
And shares kept on rallying as prices for DRAM (dynamic random access memory -- what's used to store and retrieve data in computers), firmed up. Yet as DRAM prices have slipped anew, shares have given back the recent gains.
That's why a soon-to-be released announcement from Micron is so important. The company is hammering out the final details of a major acquisition that should help control the industry supply of DRAM, enabling producers to steadily garner firmer prices for their products.
A glut will soon end
Japan's Elpida was like the unwanted neighbor that shows up at your parties. The DRAM producer kept flooding the market with its DRAM chips, even though it was losing gobs of money. All that Micron and rival Samsung could do was hope that demand would outstrip all that supply, which has rarely been the case in recent years.
Elpida's money-losing ways finally forced it in to bankruptcy, and after protracted negotiations, Micron has apparently agreed to take over the struggling firm for around $2.5 billion to get Elpida's assets, which is likely $500 million or even $1 billion more than it had initially hoped to pay. And Micron will likely spend another $1 billion to shore up the acquired manufacturing plants. But the stiff price will still be worth it.
At that price, Micron is getting Elpida's assets at $0.30 on the dollar, if the company were to make similar capacity enhancements on its own. Elpida's Hiroshima plant is said to be worth $3 billion and the Rexchip plant another $5 billion. And the purchase price is still less than half of Elpida's $5.4 billion debt load when it skidded into bankruptcy.
More importantly, a field of four major players has just been reduced to three (Samsung has around 45% market share, and Micron and Hynix will each have around 25%). That sets the stage for more controlled industry output, as the industry's loose cannon (Elpida) will no longer be flooding the market. In fact, Micron is likely to shut off some of Elpida's capacity simply to make sure industry supply will be in sync with demand.
What's the eventual payoff? Well, analysts are just starting to do the math. Credit Suisse, for example, thinks the deal, in a best case scenario, could add $0.70 in earnings per share (EPS) to Micron, or $720 million in cash flow. Most of those gains would come from further price hikes in DRAM. In an absolute worst case scenario, they see the move as neither helpful nor hurtful. They're splitting the difference on the range of assumptions, and have come up with a $12 price target (the stock currently trades for a little more than $6 right now).
Analysts at Citigroup have a similar take: "We view this deal favorably given it is consolidation in a commodity industry, is cheap relative to replacement cost, and strengthens MU's relationship with Apple (Nasdaq: AAPL)." Apple was Elpida's largest customer, and apparently lobbied for Micron to gain control of Elpida. Citigroup's $12 target assumes shares will trade past the current $8 in tangible book value and move up to 1.5 times that figure.
As noted earlier, slumping DRAM prices have been a recent impediment for this stock, but help is on the way, according to Goldman Sachs. Earlier this week, the firm issued an updated industry forecast, noting that the market will likely remain oversupplied in the current quarter, move into balance in the third quarter, "with the potential for meaningful undersupply in 4Q12." Their key takeaway: "Given a tightening supply/demand balance, we believe pricing is likely to continue moving slowly higher over the coming quarters."
Risks to Consider: To pay for the Elpida deal, Micron will be issuing fresh debt, and the interest rates it will have to pay will help determine how strong a payback it can expect from the purchase.
Action to Take --> It will take several quarters for all of this to play out. Indeed, the agreement in place may still fall apart before the paperwork is signed. But assuming the deal gets done, analysts will increasingly start to see what this industry will look like in a year or two, as industry supply gets rationalized. That should push this stock, which already trades at a sharp discount to tangible book value, back on to Wall Street's buy lists. And if the analyst price targets I mentioned earlier are indeed where this stock is headed, then we're talking about a double.
David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.
The article orignally appeared on StreetAuthority.com