Good Luck Figuring Out Applied Material's Course

It's common knowledge that the semiconductor industry is cyclical and that any company selling equipment for this industry is going to have its ups and downs. Even so, it almost feels like investors considering Applied Materials (Nasdaq: AMAT) would be better served with a Ouija board or tarot deck. Nobody questions that AMAT is a key player in the equipment used to make chips, solar panels, flat panel displays and so on, but it seems no two analysts or investors can agree on where we are in this cycle and how low the next bottom will be.

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A Solid Fiscal Second Quarter
What is certain is that Applied Materials had a solid second quarter. Revenue rose almost 7% on a sequential basis and surpassed the high end of its analyst range. Growth was led by the services and solar businesses, while the core semiconductor business was down about 3% from the prior quarter. Orders were also solid - climbing 7% - with growth everywhere but the solar business and the core chip equipment business matching that overall growth rate.

Going with straight-up GAAP reported results, AMAT saw gross margin improve more than a full point from last year, but come off about 70 basis points sequentially. Operating income was stronger on a year-over-year basis (up 75%), and up strongly on a sequential basis. To the extent that looking at cash flow can help resolve some of the non-cash items that complicate earnings reports, AMAT reported that year-to-date operating cash flow was up almost 26% from the year-ago period. (For more, see Strategies For Quarterly Earnings Season.)

Guidance the Fly in the Ointment
Even if Applied Materials did better than expected, analysts and institutions won't really care in light of weaker guidance. AMAT is seeing the impact of both the Japanese earthquake and a lot of uncertainty in the semiconductor sector; this has led management to expect revenue to drop by a mid-single-digit percentage in the third quarter.


While some analysts are still looking for a rebound in chips later this year, just as many think that inventories (and estimates) are too high and equipment orders are likely to be canceled. Taiwan Semiconductor (NYSE:TSM) and Samsung have both pushed out chip equipment orders, and panel makers like AU Optronics (NYSE:AUO) and Samsung have delayed new plant openings in China. As if that weren't enough, curtailments in government subsidies are impacting demand for solar panels and there is a risk that that backlog could start to dry up as well.


AMAT Can Wait it Out
Although AMAT did report a net loss in 2009, the company has managed to stay in the black with respect to free cash flow for the last two cyclical bottoms. What's more, the company is an entrenched market share leader in critical industries - such that it is not all that easy to build a fab without some piece of equipment from the company. The company is also continuing to plan for its future; perhaps the company is overpaying for Varian Semiconductor (Nasdaq:VSEA), but it is getting some good technology and horizontal market expansion in return. (For more on this topic, check out Applied Materials Gets Two For One With Varian.)

It's also worth noting that many major chip companies, Intel (Nasdaq:INTC) and Texas Instruments (NYSE:TXN) most notably, have made large recent commitments to new fab capacity. This new capacity is key to these companies' plans to not only expand into new markets, but to do so with a cost advantage over their rivals. In other words, new fab construction is a "when,not if" event and Applied Materials has the resources to wait out a bad turn in the market.


That sets the company apart from more specialized plays like Advanced Energy (Nasdaq:AEIS) or Cymer (Nasdaq:CYMI) - good, focused companies with niche businesses that could appeal to buyers in the space, but with more downside risk to a prolonged lull in spending. (For more, see Use Chips To Play The Technology Sector)


The Bottom Line
With so much uncertainty about Applied Material's near-term revenue and cash flow outlook, it may make more sense to evaluate the company on full-cycle averages. To that end, the stock still appears to be undervalued and worth a look. Risk-seeking investors will probably be more excited by the potential of names like AEIS, Cymer, Veeco (Nasdaq:VECO) or Ultratech (Nasdaq:UTEK). However, Applied Materials is not a bad idea for value-oriented investors who can tolerate a little risk, but may not have the same appetite for the wild ups and downs that can go with investments in the broad semiconductor sector.

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