Hoping to Ride Micron Stock Higher? Don't Ignore This Red Flag.

Micron (NASDAQ: MU) has become one of the biggest winners of the artificial intelligence (AI) boom.

Demand for the memory specialist's DRAM and other data storage products has surged well beyond the available supply. Customers have already signed contracts for most of the memory that the entire sector will be able to produce in the near future, and investors increasingly view Micron as one of the key hardware suppliers underpinning the AI revolution.

That excitement -- and the surging profits it is booking thanks to the ongoing memory shortage -- have helped lift the company's market capitalization above $1 trillion. But before new investors rush in to buy its shares, they should consider one important risk.

The risk isn't that demand for artificial intelligence will suddenly recede. The risk is that Micron's profits have become too good.

Image source: Getty Images.

Not all profits are sustainable

On the surface, it may seem strange to describe growing profits as a risk to watch. After all, investors want the companies they own to earn more money, not less. However, history shows that unusually high profits often attract competition, new supply, and eventually lower returns.

Imagine a hotel in a city that's hosting the Olympics. Thousands of visitors arrive. Rooms sell out, and with demand outstripping supply, hoteliers boost their prices to the sky. For a short period, the hotel earns extraordinary profits and returns on investments. From the outside, the business looks incredible.

But once the event ends, demand returns to normal, room prices are reset, and profit margins slide back to where they had been. The hotel's competitive position never changed. What changed -- temporarily -- was the supply-and-demand dynamic.

Investors often see booming profits and assume the good times will continue indefinitely. To be fair, sometimes they are right, especially if the trend is structural. But more often than not, as conditions evolve, profits just revert to the mean.

In the case of Micron, the challenge is determining which situation applies.

Why has Micron's profit soared?

Micron's remarkable share price performance of late was not without reason. In its latest reported quarter, net income surged more than eightfold year over year from $1.6 billion to $13.8 billion, driven by increased demand for its products.

Technology giants are investing hundreds of billions of dollars in AI infrastructure. That build-out has created enormous demand for advanced memory products. As a result, Micron has enjoyed growing sales volumes, robust pricing power, expanding margins, and growing profits.

Those are all positive developments. But strong profits alone do not prove a company has a durable competitive advantage.

In many industries, temporary shortages can create exceptional profits for several years before conditions normalize. Moreover, they tend to drive competitors to develop more production capacity, setting the stage for eventual oversupplies and terrible future returns.

That possibility in this case deserves serious consideration, as that's precisely what has driven the cyclical behavior of the digital memory market for decades.

What investors should closely track in the coming quarters

Rather than focusing on daily AI headlines, I would keep an eye on a few key indicators.

First, I would watch gross margin. A strong and improving margin trend suggests the industry continues to enjoy favorable economics.

Second, I would watch product pricing. Here, we would like to see stable or rising prices, which tend to indicate that demand remains robust.

Third, I would watch returns on capital. Great businesses continue generating strong returns even after competitors respond. In fact, both Micron and its competitors will add to their production capacities in the near term, so investors will have to gauge the impact of supply expansion.

Those metrics will tell investors far more about Micron's long-term prospects than short-term excitement surrounding artificial intelligence.

What does it mean for investors?

Investors don't always make their biggest mistakes when business conditions look bad. They often make them when conditions look so good that they stop asking the hard questions.

It may be that the artificial intelligence megatrend has permanently changed the dynamics of the memory industry. Or it may be that its supply-and-demand mismatches will follow the same patterns they always have, and that memory's boom-and-bust cycles will continue.

That is why investors should focus on one question before buying the stock: Are Micron's current profits sustainable once supply catches up?

The answer could determine whether the recent stock rally marks the beginning of a long-term growth story or the peak of another memory cycle.

Lawrence Nga has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Micron Technology. The Motley Fool has a disclosure policy.