Micron Just Eliminated Its Biggest Risk With This Brilliant Move, and Investors Are Loving it

Coming into Micron's (NASDAQ: MU) fiscal third-quarter earnings report, investors were expecting another round of smashing results, and the memory chip stock delivered.

Revenue jumped 346% year-over-year to $41.5 billion, ahead of estimates at $35.3 billion, and adjusted earnings per share surged from $1.91 to $25.11, topping the consensus at $20.28.

However, what's more important than the third-quarter results is where the company is headed. A shortage in memory chips has sent prices soaring, driven by AI-related demand, sending memory stocks skyrocketing across the board.

The memory sector is also notorious for being cyclical, as prices can swing wildly as inventory levels go from shortages to gluts and then back. The severity of the shortage is evident in Micron's results. Not only did revenue jump more than 300%, but it also recorded a gross margin of 85%. That's a better profit margin than even Nvidia is achieving, and means that Micron's chips are selling for roughly six times their direct costs. The company's operating margin was 80.4%, a level virtually unheard of in any industry. Inventory levels, meanwhile, have essentially been flat since the beginning of the year, at $8.6 billion, showing the company has exhausted its capacity.

Still, the risk to the stock at this point is that supply/demand dynamics shift, pricing starts to come down, and profit margins narrow again. That will happen at some point, and determining when it happens is the most important question to answer to correctly value the stock.

That's why a new component of Micron's business model, strategic customer agreements, or SCAs, is so important. By adopting it, the company seems to have significantly mitigated its cyclical risk.

Image source: Getty Images.

What are Micron's SCAs?

Historically, Micron has signed one-year contracts with customers. Now, with strategic customer agreements, it's signing five-year contracts for both high-bandwidth memory (HBM) and conventional chips like DRAM and NAND, smoothing out much of the lumpiness in the memory market, and eliminating the cyclical risk that has historically hammered the sector.

After signing up one SCA customer in the second quarter, Micron added 15 more in the third quarter to bring the total to 16, all booked through calendar 2030 except the auto market, which has a three-year term. Management explained that the new contracts included customers in data center, consumer, and auto market segments.

Those agreements represent about 20% of the company's DRAM volume and about a third of NAND volume, showing a significant part of its business is being converted to long-term contracts. Micron said the customers include four very large customers and three medium-size customers.

Management expects at least half of its revenue to come from SCAs, which are "structured as take or pay agreements with binding commitments to purchase specific volumes over this multi-year term."

The price bands included in the contract enable a gross margin well above the company's peak in any past cycle, and reassure investors that its margins will be reasonably stable through 2030.

Is Micron a buy?

In addition to the proliferation of SCAs, Micron also delivered strong fourth-quarter guidance. It expects revenue of around $50 billion, representing 342% growth, and gross margin to improve sequentially to 86%, leading to adjusted earnings per share of around $31.00, which compares to $3.03 a year ago.

Management also said that it expected supply demand conditions in both DRAM and NAND to remain tight beyond 2027, showing that high prices should continue through at least 2028.

Micron gained 15% after hours on Wednesday, as investors were clearly impressed by the results and guidance, but the SCAs are what stand out most. Micron's customers are eager to lock in long-term contracts, and the deals alleviate the risk of pricing turning over if AI-driven demand shifts. The SCA is a smart move for Micron, and it makes the stock a buy as the runway for further growth looks clear.

Jeremy Bowman has positions in Micron Technology and Nvidia. The Motley Fool has positions in and recommends Micron Technology and Nvidia. The Motley Fool has a disclosure policy.