Still Little Good News From Applied Materials

By Stephen D. Simpson, CFA | August 18, 2012 AAA

Two-thirds of the way through 2012, it's pretty clear that not only were expectations for a semiconductor and semiconductor equipment recovery wrong, they were off by a wide margin. As Applied Materials (Nasdaq:AMAT) continues to see business erosion, it has to test the patience of even the most loyal or long-term shareholder. While spending will recover someday and the shares will have their day again, the shares are likely to be volatile in the short term.
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So This is 'Solid'?
I have to wonder what world Applied Materials management lives on to title its third quarter earnings news release with "Solid Third Quarter Results". Not only did management guide down again back in July, but a double-digit year-over-year revenue decline is not my idea of a solid performance.

Revenue fell 16% from last year and 8% from the Q2 with spotty performance across the board. While sales in the SSG segment were up more than 10% from last year, they also dropped 13% sequentially. Conversely, while AGS and Display both showed some modest sequential growth, they were down year-over-year.

Margins, too, continue to erode with sales. Gross margin (non-GAAP) slid a half-point from the second quarter. Operating income dropped about 12% sequentially, with a roughly one-point decline in operating margin.

SEE: Understanding The Income Statement

Well ... It Could Have Been Worse!
If there is solidity to Applied Materials' performance, it is in how the company has held up relative to other players in the industry. On a relative basis, Applied Materials' financial performance compares relatively well to Lam Research (Nasdaq:LRCX), ASML (Nasdaq:ASML) and Tokyo Electron. So at least investors can find some consolation from the fact that it's just as much an industry-wide problem as a company execution issue.

That said, business is still looking decidedly unsolid. Orders dropped one-third from the Q2, with SSG orders down 41%. AMAT is still seeing the effects of a weak spending environment for memory players, including a sizable order push-out from a big foundry customer (perhaps Samsung?). As a result, management cut guidance yet again, with its revenue forecast for the next quarter about 20% below analyst estimates. Likewise, the display market remains weak - not good news for companies like Corning (NYSE:GLW).

What Now?
A handful of equipment companies are showing some relative strength, due to their positions at different parts of the semi manufacturing cycle and/or different end-market exposures. Companies like KLA-Tencor (Nasdaq:KLAC) and Hitachi High-Tech aren't doing too badly; the latter delivered a beat-and-raise quarter with positive revenue growth just a month ago.

I won't pretend to know when the semiconductor industry will finally bottom, just that eventually it will. What's more, the ongoing evolution in the industry means increasing demands on and for equipment. Applied Materials estimates that the move from 28 nm to 20 nm will increase the number of steps at various production stages by as many as 30, and that will mean more sales and higher ASPs. What's more, the incredible R&D demands of staying in the game are starting to weigh on even the big players - ASML has had to solicit customers like Intel for strategic investments to fund next-gen research. That ought to be a long-term positive for Applied Materials, as it has the capital to reinvest in R&D that smaller rivals may not.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
I know I'm in "broken record" territory when it comes to talking about AMAT's investment prospects. It's undervalued based on its long-term prospects, there's huge uncertainty about the timing of a turnaround, tech investors don't reward value with no growth, and so on.

For whatever it's worth, though, I still believe all of that. If Applied Materials were to retest valuation lows of 2 times tangible book, that would mean a further 50% lopped off the stock. But I think the sort of market/economic environment that would bring that about would crush a lot of tech stocks in addition to Applied Materials. Consequently, I do think these shares are undervalued, but I can't muster a lot of enthusiasm for owning them myself.

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

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