Micron's New Strategy Will Face SK Hynix and Samsung's $575 Billion Spending Plans

Micron Technologies (NASDAQ: MU) blew away expectations with its most recent earnings report. The company posted record profitability while quintupling revenue year over year.

But perhaps the biggest takeaway from Micron's earnings report was management's disclosure of new strategic customer agreements (SCAs). Micron signed long-term agreements with some of its largest customers, creating more predictable demand and pricing for its chips over the next three to five years.

That's important because Micron's biggest competitors, SK Hynix (KOSE: A000660) and Samsung (OTC: SSNLF), are about to invest huge sums of money in building out additional capacity. It'll be a major test for Micron's new strategy.

Image source: Micron Technologies.

Micron's biggest risk

Memory chips are, in practicality, commodities. The market has seen a surge in demand over the past year as memory has become a bottleneck in artificial intelligence (AI) training and inference. The more memory you can package with a GPU or other AI accelerator chip, the faster it can process data and generate a response.

However, it takes time for Micron and its competitors to build new capacity. As a result, memory chip prices have skyrocketed, leading to massive near-term profits for the chipmakers.

But as new fabs begin producing more chips, the supply-and-demand equilibrium shifts, and prices and profits decline. This creates earnings cycles throughout the industry. The big risk for Micron is that SK Hynix and Samsung build out more supply than Micron does, putting pressure on pricing and leaving Micron with less volume to make up the difference.

Micron's latest solution to the challenge is its SCAs. So far, it's signed 16 customers, representing about 20% of its DRAM volume and one-third of its NAND volume. The contracts are take-or-pay, which gives Micron more revenue predictability and the confidence to build more capacity. Micron says the contracts represent a minimum value of $100 billion over the course of the agreements.

Last year, Micron announced plans to spend $200 billion on new production capacity and R&D. Despite the SCAs, Micron's management didn't announce any plans to spend more. It merely stated they "provide us greater confidence in our capex (capital expenditures) and R&D (research and development) investments."

The competition just announced massive spending plans

The South Korean government recently announced a joint initiative between SK Hynix and Samsung to build a massive facility in southwestern South Korea. The facility will include four new chip fabrication plants with a total cost of about $520 billion. Separately, another $53 billion is being allocated to a new chip packaging facility.

And reports indicate that SK Hynix and Samsung plan to spend a combined 2,000 trillion won (about $1.3 trillion) on new facilities over the next decade. So, the new fabs and packaging plant may be just the start.

As mentioned, it takes years for a new facility to start producing chips, so the impact of the massive spending plans on chip pricing will be delayed. However, with a new pipeline for memory chips set to enter the market by the end of the decade, it could severely limit Micron's ability to negotiate its SCAs. And that could have a meaningful impact on its business going forward.

As things stand, Micron's current agreements account for just a minority of its revenue. The agreements cap the upside at pricing levels from its second quarter, limiting its near-term earnings potential. However, Micron's management expects supply constraints to continue benefiting pricing through 2027.

With the massive capacity build-out set to influence pricing by the end of the decade, Micron's earnings downcycle could be quite severe despite its best efforts to protect itself with long-term agreements. As such, Micron investors should be wary of paying too much for near-term earnings potential.

Adam Levy 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.