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Micron's Quarter Throws a Curveball

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The stock is getting whacked, but downfalls of this quater could set it up for future growth.

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Micron (MU) delivered one of the more convoluted and confusing quarters I've seen in a while. The stock's getting whacked as you'd expect and the big concerns I'm seeing this morning center on DRAM bit growth or the lack thereof. DRAM bit growth was a modest 2% sequentially with the expectation for "flat-to-up slightly" in the August quarter.

The issue surrounding the lack of bit growth is fairly simple. Micron has a DRAM joint venture with Nanya Technology in Taiwan called Inotera. The two owners each get half of the output. However, Inotera is in the midst of converting the way it makes its parts from what's called the trench process to Micron's stack process. This conversion is mandatory as the trench process has some very real limitations going forward. However, in order to complete the conversion, capacity needs to be taken off-line for installation of new tools. Both Micron and Nanya get fewer wafers during the transition period, hence the lack of bit growth.

With Inotera's process conversion expected to be completed in the fall, we should expect to see growth resume thereafter.

The other major curveball in Micron's results was the acquisition in early May of NOR flash supplier Numonyx. Purchase accounting can do some funny things and this was a prime example.

Micron actually had a gain on its acquisition by virtue of the fact that the value of the assets and liabilities acquired was $488 million greater than the purchase price. While that may sound rather bizarre, it's the way the system works and Micron was required to recognize $437 million in its fiscal third quarter with the rest to show up in the fiscal fourth quarter.

There's a flip side to that gain that becomes a drag on future earnings from Numonyx. First, all the acquired inventory is written up to the purchase value, hence the $700 million increase in Micron's inventory. As that acquired inventory is sold, it will be sold at essentially zero margin because they were already forced to recognize the gain on sale. Only new Numonyx production will head out the door with an actual profit associated with it.

Another aspect of this confusion involves Numonyx inventory in the distribution channel. Since the revenue recognition policy employed was on a sell-through basis (when the distributor sells to a customer), Micron doesn't get to recognize revenue on the inventory placed into the channel by Numonyx. Only when it starts shipping parts into the channel will that change.

Isn't accounting great!

The bottom line for me after all the puts and takes was demand. How is it? It's fine. Personal computer-related DRAM revenue increased 3% sequentially in a fairly slow period. More importantly, server revenues were up 22% quarter over quarter and networking/storage revenue increased 25% as well. Indications for back-to-school sales are positive. NAND flash demand remains strong with 16% sequential growth and the company now has its 25nm production ramping. And all those new iPhone 4 (AAPL) units have a multi-chip module from Numonyx!

Micron's quarter was a classic case of needing to separate the wheat from the chaff.
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No positions in stocks mentioned.
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