Leading semiconductor equipment company Applied Materials (Nasdaq:AMAT) posted stronger than expected revenue and raised guidance for fiscal 2012. So, it's off to the races, right? Not exactly. While conditions do seem to be getting better in the equipment world, analysts remain very skeptical about the persistence of this recovery and expectations for the company are all over the map. Although its valuation looks too low for the full cycle, the short-term world of Wall Street couldn't care less about more than one quarter.

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Less Bad Is Better
Applied Materials didn't have a strong quarter, but it was less rotten than many analysts feared. Revenue fell 19% from last year and was up very slightly on a sequential basis as reported. Stripping out the Varian acquisition, sales would have been down about 9% sequentially.

The company saw a big turnaround in its core semiconductor equipment business, as sales rose 26%. Offsetting this were big declines in display and solar (down 39 and 34%, respectively), with services revenue down about 15%.

Not surprising for a tech company, Applied Materials saw significant negative operating leverage. Gross margin slid about three points sequentially (more than six points annually), and reported operating income fell 72% from last year and 50% from the prior quarter. (For related reading, see A Look At Corporate Profit Margins.)

Foundry Leads the Way Back
Applied Materials saw a strong increase in foundry orders this quarter, as companies like Taiwan Semiconductor (NYSE:TSM) and GlobalFoundries continue to invest in equipment to serve the needs of fabless chip companies like Broadcom (Nasdaq:BRCM) and Altera (Nasdaq:ALTR). Foundry has long been an important customer category for Applied Materials, so this is definitely a welcome development.

That said, Applied Materials may not be the company with the most to gain here. KLA-Tencor (Nasdaq:KLAC) also has above-average foundry exposure, and together with lithography specialist ASML (Nasdaq:ASML) both have been showing stronger pricing power recently.

When Will Other Units Pull Their Weight?
Applied Materials is no doubt a strong player in front-end semiconductor equipment (holding more share than the highly-specialized ASML and about a 50% greater share than Tokyo Electron), but that's not all that the company tries to do. The company has also spent a lot of its shareholders' capital to get footholds in the flat panel and solar manufacturing equipment markets.

Unfortunately, both of these markets remain extremely weak. Not only is revenue down, but orders are incredibly low - book-to-bill in panel and solar were roughly 0.4 and 0.16 in the fiscal first quarter. Although I don't believe anybody expects display and solar to stay down forever, these attempts at diversification have yet to yield positive returns.

The Bottom Line
The semiconductor industry is pretty much always in a permanent state of flux, so the notion of "steady state" earnings here is pretty silly. That said, there is a lot of history on Applied Materials and that history shows a pretty solid ability to anticipate and adapt to evolving industry needs. In other words, the company is quite likely to remain a player in semiconductor equipment for a long time to come.

Earnings are so volatile here that cash flow modeling is difficult. That said, it is possible to get a sense of "full cycle" performance and by that standard Applied Materials seems too cheap. Unfortunately, tech investors generally buy on the basis of momentum not value, and momentum is likely to be stronger with ASML and KLAC for the time being. Value-oriented investors may find the price of these shares to be appealing, but any buyers today need to have a long-term horizon and a lot of patience to weather the uncertainties of the cycle and the bipolar responses of the sell-side analyst community. (For related reading, see Buy Side Vs. Sell Side Analysts.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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