Micron Technology (M)Memory chip maker Micron on June 26 reported strong results for the fiscal third quarter ended May 30. The company returned to positive free cash flow (FCF) despite increased capital expenditures, and said it expects this to continue going forward.
The company sees strong future performance due to strong demand for memory chips related to enabling artificial general intelligence (AGI). The company raised both revenue and capital expenditures estimates, although management expects positive free cash flow growth in the fourth quarter.
As a result, MU stock looks undervalued here. Based on the projected FCF, MU stock could trade at $162.44, or 23.5% higher than its price of $131.53 on June 28. Additionally, shorting out-of-the-money (OTM) put options could make sense. We’ll discuss these points in this article.
Generating positive free cash flow (FCF)
Micron’s DRAM and NAND memory chips were in high demand in data centers and AGI-related applications. Revenues increased 16.9% sequentially to $6.811 billion. Additionally, gross margins increased 20% sequentially to 28.1%, while operating margins soared 3.5% sequentially to 13.8%. The company posted a loss in the prior year.
As a result, the company generated strong operating cash flow of $2.482 billion, representing a 36.1% margin on revenue of $6.811 billion. Micron made more than $2 billion in capital expenditures during the quarter, which helped the company return to positive adjusted FCF of $425 million.
Micron Technology Q3 FCF – Earnings release June 26th
This implies a positive FCF margin of 6.2% (i.e., $425 million / revenue of $6,811 million).The company also announced that it will make capital expenditures of $3 billion in the fourth quarter, but will still be free cash flow positive.
This is why Micron’s outlook is so bright: analysts can expect positive FCF margins, for example, due to rising revenue estimates.
FCF forecast
For example, analysts are currently forecasting revenue of $37.74 billion for the next fiscal year ending August 2025. This would be an increase of more than 50% from the $25.04 billion forecast for the current fiscal year ending August 2024.
Here’s how to forecast FCF: With revenue increasing 50%, we can assume that Micron Technology’s operating cash flow margin will increase by at least 30% from 36% last quarter, which would bring its operating cash flow margin to 46.8%. We also assume that capital expenditures average $3.5 billion per quarter, or $14 billion for the year. This is a 75% increase from the $8 billion planned spending this fiscal year.
That translates into operating cash flow of $17.66 billion (i.e., $0.468 x $37.74 billion) and FCF of $3.16 billion (i.e., $17.66 billion – $14.5 billion). This implies an FCF margin of 8.4% next fiscal year, up significantly from last quarter’s adjusted FCF of $425 million and adjusted FCF margin of 6.2%.
This amount of FCF will also enable Micron to continue paying down its total debt of $13.3 billion, not including the $9.2 billion in cash already on its balance sheet, putting the company in a healthier financial position and likely driving a higher market valuation.
MU stock target price
For example, the market is likely to give MU stock an FCF yield (i.e., FCF/market cap) of at least 1.5%. For example, if we divide the estimated FCF of $3.16 billion by 1.5%, we get an expected market cap of $210.7 billion, which is 41% higher than the current market cap of $149.3 billion.
However, even using a more conservative 2.0% FCF yield, our market cap estimate is $158 billion (i.e. $3.16 billion / 0.02 = $158 billion).So, on average, assuming an FCF margin of 8.4%, we can expect the market cap to reach at least $184.4 billion at some point next year.
That’s 23.5% higher than its market cap today. In other words, MU stock is worth 23.5% more than it was worth on Friday, June 28 at $131.53. This makes the price target $162.44 Per share.
Analysts tend to agree: For example, a Yahoo! Finance survey of 30 analysts has a price target of $167.12, a Barchart survey has $159.30, and AnaChart, a new sell-side analyst tracking service, reports that 31 analysts have an average price target of $153.29.
The bottom line is that MU stock looks undervalued here, both from a bottom-up analysis of FCF estimates and from other analysts: One way to take advantage of this is to short out-of-the-money (OTM) put options.
Short OTM puts
For example, let’s look at an expiration date on July 19th, three weeks from now. We see that a put option with a strike price of $127.00, 3.44% below today’s price, is trading for $2.59 on the bid side.
This represents an immediate yield of 2.0% (i.e., $2.59 / $127.00) for the short seller.
MU put options expiring on July 19th – Barchart – as of June 28th
This means that an investor who sets aside $12,700 in cash and/or margin through their brokerage would receive an immediate income of $259, since a short put play requires setting aside cash to purchase 100 shares at the strike price that was shorted.
But it also offers these put short sellers better protection against a decline in the breakeven point: for example, $127 minus $2.59 would give them a breakeven point of $124.41 per share, 5.4% below the spot price of $131.53.
Furthermore, if the investor were to repeat this trade every three weeks each quarter, the expected return (ER) would be $1,036 (i.e., $259 x 4), or 8.16% on the $12,700 invested each time. While there is no guarantee that this yield will be earned each time, this shows that this trade currently has a high ER for the investor. Also, if the stock price falls, the investor’s cash will be burned at a lower price, providing additional income.
The bottom line is that MU stock looks undervalued here, and one good way to take advantage of this is to short OTM put options with a nearby maturity period.
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On the date of publication, Mark R. Hake, CFA did not hold (either directly or indirectly) any positions in any of the securities mentioned in this article. All information and data in this article is for informational purposes only. For more information, please see Barchart’s disclosure policy here.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
