AN INTERVIEW WITH Eric Gregg
Luke Schiefelbein Contributor
Jul 10, 2018, 05:07pm • 625 views • #StockWatch
Eric Gregg is the Founder and Principal of Four Tree Island Advisory LLC
Why Micron Is Front And Center In The Trade War
Last month, the New York Times shocked the semiconductor industry with an
article detailing an elaborate heist of corporate secrets from Micron Technology’s
Taiwan office. The article, and later coverage in the Wall Street Journal uncovered
systematic corporate espionage by Chinese state-backed entities seeking to
jumpstart China’s semiconductor industry. In the weeks since, Idaho-based
Micron has become a flash point in the budding trade war between China and the
Eric Gregg, the founder and principal of Four Tree Island Advisory, submitted a
comprehensive long report to SumZero on Micron. SumZero sat down with Gregg
to discuss Micron, the semiconductor industry and the implications of a trade war
between the U.S. and China.
Luke Schiefelbein, SumZero: What about Micron initially caught your eye as
a value investor? What sparked your interest in the name?
Eric Gregg, Four Tree Island Advisory: My initial interest was perked due to
my work in the Wafer Fabrication Equipment (WFE) sector. I’ve become a strong
believer in a) the long-term secular growth dynamics gripping the WFE sector b)
that there is a sizable valuation disconnect between top companies and their
underlying fundamentals, and c) that the outlook for memory is fundamentally
better than what the market is buying into (which provides strong underpinnings
for the top etch and deposition WFE companies). Given Micron’s historically
volatile operating and stock price history and at times seemingly over-leveraged
capital structure, it took some work to become not only comfortable, but
enthusiastic about the potential for Micron’s stock. I’ve come to believe that
Micron is fundamentally a different company now than it was just three years ago
due to the robustness of its end markets, its tri-opoly industry structure (at least in
DRAM), its significant technological gains vs. the competition and the increased
capital and technical complexity that are driving meaningful barriers to
competition. Throw on top of that that the stock is the cheapest stock in the S&P
500 based on forward earnings and it reads as a highly compelling investment
Schiefelbein: Your initial report (12/18/17) covered the various outcomes for
Micron given the potential of material disruption to DRAM/NAND production in
Korea. Is there any likelihood of disruption of the Korean DRAM/NAND supply
chain similar to Thailand’s 2011/2012 flooding?
Gregg: That was one of the three potential levers (the other two in the report were
the potential for something strategic to happen with Intel (the impetus being some
buyout provisions that kick-in in January of 2019 around the Intel Micron Flash
Technologies JV) and for company and industry fundamentals to continue to
improve and the stock re-rate). While the likelihood of a disruption in supply due
to conflict on the Korean peninsula appears more remote now than it did back in
December of 2017, a) it is still a possibility (the WSJ just this week reported that
North Korea continues to expand a key missile manufacturing facility and the
message Secretary Pompeo conveyed during this week’s visit to North Korea was
not well received) and b) we now have a different conflict (a trade conflict with
China) that is having a more meaningful impact on Micron specifically and the
semiconductor industry in general.
MORE FROM FORBES
Schiefelbein: What catalysts should investors pay attention to as your thesis
1) The biggest overhang on the stock is the China trade conflict situation. The
main China trade related concern at the moment is there is a commercial dispute
that China appears to be using as a means to force technology transfer and inflict
pain on Micron as retribution for the US’s treatment of ZTE. If/when this issue is
resolved, that should be a major catalyst for the stock.
2) Continued strong operating performance
3) DRAM and NAND pricing per bit that doesn’t drop more than costs per bit
4) Continued indications of a robust global economy (Micron and the semis are
considered to be a pro-cyclical investment play despite there being strong evidence
of some important secular growth and individual company repositioning themes
at play for Micron).
Schiefelbein: Why is memory pricing so volatile and cyclical? Do you expect
DRAM/NAND memory to continue towards commodification?
Gregg: There are two different markets: DRAM and NAND. DRAM is showing
strong signs of being a much more rational and disciplined market. Growth
forecasts are for 20%+ annual bit growth for at least the medium term. Shrinks in
DRAM are becoming notably more complicated and expensive. For all practical
purposes there are only three sizable DRAM manufacturers and there are serious
questions about whether new players (mainland Chinese) will be able to
successfully compete in leading edge DRAM. On the NAND front, medium term
forecasts suggest a 40+% bit growth rate. With higher anticipated growth, more
ways to achieve that growth (moving from TLC (tri level cell) to QLC (quad level
cell), for instance, provides a 33% increase in bits per chip – moving from 64
layers to 96 layers provides 50% more bits per chip) and more major competitors
in the space (currently six), there is decidedly more risk of continued
commodification of 3D NAND. As the dynamics in DRAM appear to be
transcending to much more healthy and disciplined industry behavior (and DRAM
is typically 70%+ of memory revenues for the major players and over 80% of
operating profit), I believe the industry structure is changing significantly for the
top three memory semi manufacturers (Samsung, SK Hynix and Micron).
Schiefelbein: How could the recent protectionist American shifts in trade policy
impact Micron (with ~50% of sales made to China)? What is your best / worse
Gregg: This is, without question, the billion dollar question and topic of the
moment for Micron.
There are three, principal areas of risk for Micron:
1. The US limits the sale of Micron’s chips to China (I discuss this in my
update and think this risk is low)
2. China fines Micron and the other DRAM memory semis for charging too
much for DRAM (I discuss this in my update as well, hard to estimate the
likelihood of this one maybe 50%/50%).
3. China enforces IP to a) protect the IP it stole from Micron by using its
enforcement to compel Micron to license its IP to China and b) harm
Micron as retribution for the US’s treatment of ZTE (this appears to have
According to a press release from UMC on Tuesday, a Chinese regional court ruled
in UMC’s favor and a preliminary injunction has been issued enjoining Micron
from selling 26 of its products in China. Micron Thursday issued a news release
acknowledging receipt of the ruling, but also highlighted that the 26 products
impacted by the ruling only account for ~1% of Micron’s revenues.
Before going into the best and worst case scenarios, just a little background. UMC
was hired by Fujian Jinhua Integrated Circuit (which is about finished building a
$6 billion semiconductor plant according to the NYTimes) to provide the
technological specifications it needed to make memory semiconductors. UMC has
no recent history of producing leading edge node memory semiconductors.
According to Taiwanese police reports and a criminal indictment of UMC in
Taiwan, the Company stole the IP (at the direction or at least consent of Fujian
Jinhua IC) for its memory chips from Micron and is now, according to Micron, in
turn suing Micron for IP infringement as a “proactive defense” due to Micron’s
efforts to bring UMC and Fujian Jinhua IC to justice for its misappropriation of IP.
What makes this situation especially absurd is that:
1) According to Micron they have been found guilty in Chinese court without ever
having been allowed to present a defense (due process, at least in this instance, is
apparently an alien concept in China).
2) Micron asserts that the patents being enforced by UMC are not used in Micron’s
DRAM and NAND technology or products.
3) Chinese courts don’t recognize “conflicts of interest” as a concept. With Fujian
Jinhua Integrated Circuit owned by industrial companies that are owned by the
regional government whose courts heard the case (and the Chinese courts
exhibiting a poor record of siding against de facto state owned enterprises), the
set-up for Micron to have an initial positive outcome was, in retrospect, an uphill
4) It is clear based on Micron’s press release that it hasn’t been determined by the
Chinese authorities yet whether these patents that the Fujian court has ruled as
having been infringed are even valid patents.
The fact that the ruling hit the market on the day before the 4 of July has been
construed by some as a clear swipe directed at the Trump administration and both
a) retribution for what has transpired to date with ZTE and b) an indication of the
types of measures China will take if this trade conflict continues to ensue.
What also needs to be appreciated is what this case probably means to China (or at
least the Fujian regional government). This case was filed in China a month after
Micron filed its complaint against Fujian Jinhua Integrated Circuit and UMC in
the Northern District of California which could have global ramifications for UMC
and Fujian Jinhua if the case is resolved in Micron’s favor. China’s court system is
typically faster than the US’s, but this case has moved with remarkable alacrity.
Given the background that UMC and Fujian Jinhua clearly (based on Taiwanese
police investigations, their criminal indictment, and Micron assertions) compelled
new hires to steal from Micron and then purposefully destroyed and hid evidence
from authorities on a large scale, China (or better said, the Fujian regional
government) has effectively attempted to “cleanse” their illicit behavior through
their state controlled court system (justice is not blind in China). With it likely to
take at least six to 18 more months for the US judicial system to conclude its
process, China/UMC/Jinhua have given themselves a) leverage with Micron b)
China/UMC/Fujian Jinhua can purport to be free and clear of wrongdoing
because their court system has ruled so (and not suffer the embarrassment of
being convicted by the US court system before being partially exonerated by the
Chinese judicial system) and c) China has sent a clear message to other Chinese
companies that this type of activity (stealing trade secrets and then suing foreign
companies that generated the IP for infringement) is not only condoned but will be
protected by the State. The most likely desire of all the Chinese parties involved is
for Micron to a) drop its suit in the Northern District of California and b) an
agreement by Micron to license its tech (that which was stolen and ideally other
core tech that Micron has developed) to its emerging Chinese competitors.
There are a number of ways this situation could unfold:
Micron can appeal and actually defend itself and any injunction could
presumably be suspended until the outcome of the appeals process.
There’s a reasonable argument that could be made that the Fujian regional
government/court ran amok in this situation and that the greater Chinese
government could reverse this dust up. It appears that this Fujian regional
court is playing fast and loose and a) not waiting to hear whether or not
these patents are indeed valid before ruling in favor of its own interests
(typically validity is determined before infringement) and b) not allowing
the defense to present its case, again, to the benefit of its own interests.
If Micron succeeds in its case in the Northern District of California against
Fujian Jinhua and UMC, that could in turn lead to significant leverage for
Micron over those two entities. It is very possible that the Chinese judicial
actions may help accelerate the case in California’s Northern District.
Fujian Jinhua IC is only expected to be up and running with memory
products come 2019. Injunctions could be placed on any products sold into
the US market (or potentially even globally) that incorporate a Fujian
Jinhua IC semiconductor and penalties could be imposed. Also, UMC
trades in the US and various penalties could be imposed on them.
If Taiwanese authorities succeed in their criminal prosecution of UMC, that
could also further improve Micron’s likelihood of prevailing.
It is clear based on Micron’s press release that it has yet to be determined
whether or not the patents in question are valid. While the regional court
can determine infringement and prescribe injunctions and other penalties,
only the State Intellectual Property Office in China can determine validity.
Typically that takes a year or two and this case has only been in the courts
for less than six months. According to Micron, the patents being enforced
are invalid “because they are directed to technologies that were previously
developed and patented in other countries by other technology
companies.” China is establishing very bad precedent if Micron’s
contentions are accurate and China upholds the patents regardless.
If this is simply China playing dirty (fixing the legal outcome despite the
merits) to a) retaliate against the US for the ZTE situation and b) to
penalize Micron for not acquiescing to as much tech transfer as Samsung
and SK Hynix (Micron’s investment in manufacturing capacity in China is
much more limited than Samsung or SK Hynix), that in many ways plays
right into the Trump administration’s hands and provides further evidence
of bad Chinese trade behavior. This situations could a) lead to a further
ratcheting up of trade tensions or b) help force a better broad trade
agreement that also involves a more positive outcome for Micron.
Given that this ruling only impacts ~1% of Micron’s business, the initial
impact on Micron is negligible. But if this type of state and judicial
sanctioned misappropriation of IP with subsequent IP enforcement on
foreign companies is allowed to stand, it could present a very slippery slope.
Having presented some of the issues on the table:
Best Case Scenario – US and China come to some kind of agreement Micron goes
back to operating per normal (with Micron possibly having to agree to build more
capacity in China). It is impossible to know how soon this could come to pass, but
I believe that both sides (US & China) want to come to some kind of resolution
sooner than later. China’s broader stock markets are down ~20% YTD. China’s
economy is slowing while its debt markets are showing signs of strain. China has
had to inject significant emergency liquidity into its financial system to calm fears
brought about by this trade row. The Trump administration’s approach to
improving trade balances are facing blowback from top congressmen from both
parties, the US’s allies, from some major US employers (like GM) and from some
of his core voting block. This all could come to some kind or reasonable
resolution sometime over the next few weeks/months and sufficiently in advance
of the mid-term elections.
If some material headway were achieved between China and the US to ratchet
down trade tensions, that would be highly positive for Micron.
Worst case scenario – actions, not just rhetoric, on the trade front escalate in a
meaningfully negative way causing the next global recession. Micron obtains a
hard ban on selling any products to China (and the Company has to sell its supply
previously oriented to China elsewhere at lesser prices because of a weakening
global economy). Investment in the cloud, big data, AI, IOT, increasingly smart
driving technology, higher memory content in mobile devices all decelerate
significantly. Long term demand expectations for DRAM and NAND bit growth
drop from 20% and 40%, respectively, to something meaningfully less than that.
Ironically, Micron’s valuation (multiple of earnings) is likely to go up in this
scenario, but not enough to compensate for how much earnings are likely to
I think the best case scenario is dramatically more likely than the worst case, but
there are many potential scenarios in the middle that could come to pass.
One last comment in this area. The way China is behaving here has got to be a
serious warning to all other tech companies working in and around China and
even Taiwan. While the Korean semi companies may benefit in the short-term,
longer term they and every other semi company should be thinking very carefully
about how China’s behavior could be easily turned on them. This should work to
the detriment, over the long-term, to how foreign companies cooperate
with/invest in China.
Schiefelbein: Will Moore’s Law continue to hold true over the medium term
Gregg: Moore’s law is already breaking down in a big way in DRAM. The
technological complexity is such that the major DRAM manufacturers are
spending a lot more to achieve less gain in terms of shrinks. This is one of the
primary reasons why DRAM is becoming such an attractive product. Demand
growth has stayed robust (driven largely by cloud/big data and more DRAM
content in mobile devices), but obtaining bit growth through shrinks is not even
close to keeping up. In NAND, currently bit growth is staying very much on track
with Moore’s Law, but not because of shrinking cell sizes. Much higher bits per
chip are being achieved by vertical scaling and splitting memory cells into fourths
from thirds which is materially increasing memory capacity per cell. In logic,
major semis are having difficulties (Intel most notably at the 10nm node) ramping
at smaller and smaller transistor sizes. Process complexity is increasing and some
of the newest tools needed to manufacture at smaller transistors sizes (5nm and
7nm) can’t process nearly as many wafers per hours as traditional deposition and
etch tools can at 10nm and above.
Schiefelbein: What is your take on the recent New York Times article exposing
the “heist” of IP from Micron’s Taiwan office? What impact could an insurgent
state-subsidized Chinese memory industry have on Micron?
Gregg: The NYTimes article was good, but the WSJ article added even more to
the story so should be read as well. And most important is to read the press
release issued by Micron recently. The question is even with what China has misappopriated
and with all the talent it has hired away at 3-5x prior salaries at
competitors (like Micron), how quickly will China become a real competitor in this
market. There is also the question of what remedies will foreign companies and
foreign states (like the US) enact on China for its illicit activities. Big picture, most
industry observers believe that China will not have a major impact on these
markets for a number of years. The WFE companies do expect demand for their
tools to ramp, but they have been very restrained in their expectations for how
quickly domestic Chinese companies will become major competitors at leading
edge nodes in memory and logic semis. As long as secular growth trends continue
for DRAM and NAND, there should be plenty of demand to go around.
Schiefelbein: How does your background as the CEO of OTO Technologies play
into your investment philosophy?
Gregg: Interesting question. My time leading Oto helped me develop a broad
understanding of how IP is developed, acquired and monetized in the market
place. It was a great complement to the work I did as an investment banker at
banks like Goldman Sachs, Deutsche Morgan Grenfell, DLJ and Credit Suisse.
That work ran the gamut from credit analysis, to capital markets, to advisory to Csuite
executives on how to best drive shareholder value. My time leading Oto
helped cement my broader view about looking for “fat pitches” and investments
with the following characteristics:
High ROIC, ROE, RONA business
Strong current or emerging cash flow or profitability underlying the
Expectations priced into an investment that are moderate or preferably
lackluster that provide significant upside to the extent that the market is
likely to come around to revisiting those expectations higher
Attractive valuation ideally vs. both peers and the broader market
Management evidencing a smart history of capital allocation
Attractive growth characteristics
Companies that have the potential to significantly re-rate that are going
through either strong secular change or are still early in a notably
Schiefelbein: What is the biggest risk to your thesis? Why?
Gregg: Similarly to how all people die from the same cause (lack of oxygen to the
brain), the biggest risk for memory firms time and again is when the
supply/demand relationship develops in an unforeseen manner. If demand drops
precipitously for both DRAM and NAND just when significant new capacity needs
to be digested by the market, memory prices drop like a stone as do stock prices.
There are numerous secular trends that are stoking robust demand and a few
major forces (significantly increasing capital intensity, technological complexity
and more disciplined industry structure/behavior) which are providing more
disciplined supply growth. Based on Micron’s rock bottom P/E and EV/EBITDA,
the market is clearly pricing in that the best has already transpired and that some,
seriously negative (for the memory semi manufacturers) supply/demand
imbalance is likely to come in the near term. I submit that the market is wrong.
And even some notable recent bears like Tim Arcuri at UBS have started changing
their tune and become more positive on Micron.
Schiefelbein: Where else do you see value in the market today? Where else
does your fund focus?
Gregg: Our core strategy (“The Capital Appreciation Strategy”) is heavily
weighted in tech and financials at the moment. Tech is split between some blue
chip GARP investments (like Facebook, Google and Apple) and then a number of
WFE, semi and capital equipment stocks that are all suffering at the moment from
these trade fears but that I believe will be a home run over the next 12-24 months
as some of these clouds are likely to dissipate. What I like about large/mid-cap
tech we’re invested in right now is you have secular growth drivers, typically
significant excess cash balances (that these companies are just now, due to tax
reform and better ability to repatriate cash, looking to use proactively to create
major shareholder value), enormous profitability and undemanding valuations
relative to the broader market.
On the financials side, I like insurance (AIG – a great turnaround story with new,
competent management in the saddle and Voya – now a clean story with the best
forward EPS growth, highest ROE in its peer group and smart acquisition
candidate) given where we are in this economic and rate cycle. I also like AerCap,
which I submit is a massively undervalued commercial aircraft leasing company
(that also would be a smart takeout candidate (maybe even an LBO candidate)).
AerCap has been effectively doing a “rolling lbo” for more than two years now
typically buying back 3-4%+ of its stock every quarter. They are in an awesome
sector with high demand for their aircraft, much higher margins than typical
lenders (and their “loans” are effectively secured) and with the strong, secular
growth in passenger miles flown each year. AerCap trades for less than 8x
anticipated earnings and at a significant discount to the market value of its fleet of
Overall, it’s been a volatile year-to-date for the Capital Appreciation Strategy
(unlike 2017 when our strategy was up ~32% after fees), but I believe we’re well
positioned for the latter half of 2018 and over the next 12-24 months, absent a
recession hitting (which I don’t anticipate over that period).
Disclaimers: Past performance is no guarantee of future results. All information
is gathered from sources believed to be accurate, but the accuracy of the
information cannot be guaranteed. A number of points made are matter of
opinion and opinions are subject to change without notice.
For the full report with updates and commentary visit SumZero, the world’s
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