Applied Materials (Nasdaq:AMAT) is an interesting company (and stock) today. With 3D chips on the way, it looks like the semiconductor equipment industry is looking at both a large increase in orders and a change in the sort of equipment that chip companies will need to stay on the leading edge. With strong share in equipment categories that should be essential to FinFETs, Applied Materials should be looking some strong years. But as this quarter highlights pretty clearly, there are a lot of unknowns about timing and investors are still a little hesitant about bidding up these shares ahead of the next cycle.
Fiscal Q3 Still Just Marking Time
Current conditions are still pretty challenging for Applied Materials. Revenue fell 16% this quarter (up very slightly on a sequential basis), with core SSG and AGS revenue down 18% and 14%, respectively. Gross margin came in all right (up more than a point from last year and down just slightly from the prior quarter), while operating income fell more than one-quarter from the year-ago period and rose almost 10% sequentially. 

SEE: Earnings: Quality Means Everything
And Orders Are Problematic
I don't want to say that investors don't care about AMAT's revenue and margins, but I will say that the company's outlook and orders have a lot more to do with what usually moves the stock. To that end, the 12% sequential decline in orders wasn't great news. As seen and heard from the much-smaller Ultratech (Nasdaq:UTEK) earlier in this reporting cycle, foundries and logic chip companies are pushing back their orders, and AMAT reported a nearly 50% sequential decline in foundry orders.
Orders have been stronger lately in memory, and that is incrementally positive for Lam Research (Nasdaq:LRCX), as Lam has meaningfully greater exposure to memory than AMAT or KLA Tencor (Nasdaq:KLAC) at present.
AMAT Should Have The Right Tools For The Next Cycle
One of the key bull arguments for Applied Materials is that the transition underway towards 3-D chips is going to lead to a major surge in new equipment orders. Not only do these new chip designs require higher process intensity (more steps in the production process, and thus more tools), but companies like ARM (Nasdaq:ARMH) and IBM (NYSE:IBM) have published papers highlighting a shift from lithography driving the performance improvements to new materials and design.
With that, Applied Materials' strong overall share in areas like implant, rapid thermal processing, epi, CMP, PVD/PECVD should see the company win a lot of these orders. Along similar lines, it may end up pushing companies like Lam Research, KLA Tencor, and Tokyo Electron into the M&A market to shore up areas important in the 3-D production process.
New Management Coming In At The Right Time
With Applied Materials likely looking at strong growth in display, improvements in solar, and the aforementioned shift toward 3D architectures, I think new CEO Gary Dickerson is coming in at a good point in the company's cycle. Moreover, I think his experience and performance at Varian prior to its sale to Applied Materials should be encouraging for Applied Materials investors.
The Bottom Line
I'm very conflicted on the valuation on Applied Materials' shares. To the extent that AMAT's cash flows can be modeled more than a year or two ahead, the shares seem undervalued below $19 on the basis of the next up-cycle in the equipment space. On the other hand, relative to tangible book, normalized return on equity, and normalized earnings, it's harder to argue that the shares have much room to run.
I suspect that multiples will expand here once the order book starts to fill up again, but by no means is that a risk-free call. Consequently, while I'm bullish on Applied Materials, it's not exactly what I'd call a high-conviction pick today.
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.