No. 43: Echoes of Intel, What the Oil Industry and Biology Have in Common
Echoes of Intel in Micron
I see Micron becoming an Intel-like situation, with not much capital coming back to shareholders in the end.
Intel, in its glory days, stuck every dollar of profit back into the next generation of chips. They were miles ahead of competition. Therefore, you could guess that the business would gush cash the following year. However, at the end of each year they'd bet the farm on the next generation of chips just to keep the cash gusher going.
The only real returns to shareholders came much later on as Intel started paying a dividend. However, that was also the point where the business was rotting and falling behind TSMC - therefore obsolete with zero terminal value.
They ran on a hamster wheel that kept getting faster, and ultimately had no business value remaining at the end of each year.
Micron ultimately reminded me of this - except worse...
I thought Micron would have a gentleman's agreement with Samsung and SK Hynix to limit capacity and therefore send more cash back to shareholders as a group. However, my expectations were shattered in 2022 when Samsung decided to pull the rug out from under SK and Micron by cutting prices and taking market share. Essentially they ruined 2-3 years of profitability for all memory manufacturers.
Micron got stuck using cash to fund unsold inventory and cover losses. Valuing Micron at that point would have meant ascribing optimism to the oligopoly relationship going forward - which is a shaky assumption at best, as I've detailed in my previous post Good-Time Cartels.
Additionally, investing in Micron would imply confidence that management could pick the right technologies to back. This was maybe a good bet to some extent, given that they captured huge market share of auto and industrial automation. But they missed out on AI being underexposed to HBM (High Bandwidth Memory).
Potentially the business does get better over time. But there's nothing to indicate that it would - even though the current stock price projects a rosy consensus about a cyclical upturn around the corner.
One criticism of my argument could be that TSMC is doing the same thing as Intel with great success. It effectively has no competition - and is extremely profitable. My point here would be that all of their capital is tied up on a tiny earthquake-prone island which is a geopolitical piñata.
Now to the better place for my money:
Semicap
The larger companies that make semiconductor manufacturing equipment (Lam, KLAC, Tokyo Electron, Applied Materials, ASML etc.) seem better long term holds for me (though currently pricey). They are each somewhat monopolistic, having set territories where they play without much competition. They are low capital intensity and therefore spew out cash that is returned directly to shareholders in the form of dividends and buybacks.
Low capital requirements mean that these companies can keep returning cash to shareholders. But they still benefit from increasing semiconductor capital intensity increases in the coming years. Not to mention they probably have a net benefit from the geopolitical fights around semiconductors, as semiconductor IDMs look to duplicate fabs offshore and secure supply chains.
For me this was the best way to make a bet on the industry in 2022 - when they were trading around 10-12x earnings, with almost 100% cash flow conversion.
Of course I missed taking a big swing at NVIDIA, but I sleep better at night knowing that 90% of my franchise value does not have to be won back every year.
Oil Companies and Punctuated Equilibrium
I enjoyed Pulak Prasad's book "What I Learned About Investing from Darwin." I found the chapter on Punctuated Equlibrium quite interesting. Here's a summary from Chat GPT:
Punctuated equilibrium, proposed by Stephen Jay Gould and Niles Eldredge in 1972, posits that evolution is characterized by long periods of stability punctuated by brief bursts of rapid change. This theory suggests that species often remain unchanged for extended periods until faced with significant environmental pressures, leading to quick bursts of evolutionary adaptation. These periods of rapid change are triggered by factors such as new predators, climate shifts, or habitat disruptions, resulting in the emergence of new species or significant adaptations within existing ones. Despite its focus on rapid change, punctuated equilibrium does not discount gradual evolution, instead emphasizing the intermittent nature of evolutionary dynamics.
Businesses are living, breathing organisms. Therefore the idea of Punctuated Equilibrium is quite interesting to explain what happened in the oil industry over the past few years:
2014-2016 - Proliferation of shale output in the US leading to massive overhang of supply and pricing.
2016-2020 - Period of lower profitability and returns on invested capital across the industry. Cheap debt keeps most of the zombie companies alive.
2020 - COVID lockdowns cause massive demand drop in oil, wiping out zombie companies while prices (albeit momentarily) to go to -$37/barrel. The graveyard of dead oil companies is massive.
2021-2022 - COVID lockdowns disappear and oil demand returns. Supply shocks additionally come from Ukraine War - driving prices >$100/barrel. Surviving companies are able to negotiate or pay off their debt almost entirely. The industry emerges from 2022 with a clean balance sheet.
2023 onwards - New equilibrium (until the next surprise) of 100m/bpd global demand, plus regional conflicts causing potential supply shocks. Persistent climate wokeism suggests that a constructive solution to CO2 emissions is to shut off capital to the fossil fuel industry - further increasing returns on capital. Oil companies still have clean balance sheets and high ROCE vs. pre-2020.
Big changes in the environment led to oil companies turning from a weak species into a strong one. Perhaps that's what happened to humans when the first man-ape was born with opposable thumbs.