Micron Technology (MU), the memory chip maker, delivered impressive results on June 26 for its fiscal Q3 ending May 30. Micron returned to generating positive free cash flow (FCF) despite increased capex spending. Moreover, the company said it expects to continue doing this. 

The company expects strong results in the future from strong demand for memory chips related to enabling artificial general intelligence (AGI). It raised estimates for both revenue and capex spending. However, management expects to see positive free cash flow growth in Q4.

As a result, MU stock looks cheap here. It could be worth $162.44, or 23.5% more than its price on June 28 of $131.53, based on projected FCF. Moreover, shorting out-of-the-money (OTM) put options makes sense. This article will describe these points.

Generating Positive Free Cash Flow (FCF)

Micron's DRAM and NAND memory chips were in high demand in data centers and other areas related to AGI. Revenues were up 16.9% to $6.811 billion over the prior quarter. Moreover, its gross margin rose from 20% to 28.1% on a Q/Q basis, and operating margins skyrocketed from 3.5% to 13.8% Q/Q. The prior year it was making losses.

As a result, the company generated a strong operating cash flow of $2.482 billion, a margin of 36.1% on revenue of $6.811 billion. Micron spent over $2 billion in capex during the quarter. As a result, the company returned to a positive adjusted FCF of $425 million.

That represents a positive FCF margin of 6.2% (i.e., $425m/$6,811m revenue). The company also said it will spend $3.0 billion in capex in Q4, but will still make positive free cash flow.

That is what makes Micron's outlook so positive. For example, analysts can forecast positive FCF margins on higher revenue estimates.

FCF Projections

For example, analysts now project $37.74 billion in revenue for the next fiscal year ending Aug. 2025. That represents a rise of over 50% from $25.04 billion projected for this year ending Aug. 2024.

So here is how we can project FCF. With 50% higher revenue, we can assume Micron Technology makes at least 30% higher operating cash flow margins, up from 36% this past quarter. That puts its operating cash flow margin at 46.8% Let's also assume its capex spending averages $3.5 billion a quarter, or $14 billion annually. That is up 75% from the $8 billion it expects to spend this fiscal year.

That means that operating cash flow will reach $17.66 billion (i.e., 0.468 x $37.74b) and FCF will be $3.16 billion (i.e., $17.66b-$14.5b). That represents an FCF margin of 8.4% next fiscal year. That is a dramatic increase from the $425 million in adjusted FCF this past quarter and 6.2% adj. FCF margin. 

This amount of FCF will also allow Micron to continue to pay down its $13.3 billion total debt. That does not include the $9.2 billion in cash it already has on the balance sheet. This will make the company more sound financially and the market will likely increase its valuation.

Target Price for MU Stock

For example, the market will likely give MU stock at least a 1.5% FCF yield (i.e., FCF/market capitalization). For example, if dividing $3.16 billion in estimated FCF by 1.5% results in an expected market cap of $210.7 billion. That is 41% higher than its present $149.3 billion market value.

But even using a more conservative 2.0% FCF yield results in a market cap estimate of $158 billion (i.e., $3.16b/0.02=$158b). So, on average we can expect to see at least a market cap of $184.4 billion sometime in the next year assuming its FCF margins hit 8.4%.

That is 23.5% higher than today's market cap. In other words, MU stock is worth 23.5% more than its price on Friday, June 28, of $131.53. This sets the price target at $162.44 per share.

Analysts tend to agree. For example, Yahoo! Finance's survey of 30 analysts has a $167.12 price target. Barchart's survey says $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 cheap here, both from a bottom-up analysis of its FCF estimates and from other analysts. One way to play this is to sell short out-of-the-money (OTM) put options.

Shorting OTM Puts

For example, look at the July 19 expiry period, 3 weeks from now. It shows that the $127.00 strike price put options, which are 3.44% below today's price, trade for $2.59 on the bid side.

That represents an immediate yield of 2.0% (i.e., $2.59/$127.00) to the short seller.

That means an investor who secures $12,700 in cash and/or margin with their brokerage firm can make $259 in immediate income. This is because the short put play requires cash to be secured to buy 100 shares at the strike price shorted.

However, this also provides a good breakeven downside protection to the short seller of these puts. For example, $127-$2.59 brings the breakeven cost to $124.41 per share. That is 5.4% below the spot price of $131.53.

Moreover, if the investor repeats this trade every 3 weeks for a quarter, the expected return (ER) is $1,036 (i.e., $259 x 4), or 8.16% on the $12,700 invested each time. Although there is no guarantee this yield will be available each time it shows that the play has a high ER for the investor now. And even if the stock falls, the investor's cash is spent at a lower price and also generates extra income.

The bottom line is that MU stock looks cheap here. One good way to play this is to short OTM put options in nearby expiry periods.

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On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.