Applied Materials - Investors Applaud Management For Taking All The Right Steps

Aug.19.13 | About: Applied Materials, (AMAT)

Shares of Applied Materials (NASDAQ:AMAT) saw an uptick following the company's weak third quarter earnings report. The announced management changes were applauded by investors as the company is taking the right steps to boost its long term appeal.

As the display business starts to contribute, while cost cutting efforts are geared towards research & development spending, to increase the rate of long term revenue growth, Applied is taking the right measures to create long term shareholder value.

Third Quarter Results

Applied Materials generated third quarter revenues of $1.98 billion, down 15.4% on the year before, but up 0.5% compared to the second quarter. Revenues fell short of consensus estimated at $2.06 billion.

GAAP operating earnings fell 22.4% to $250 million. Net income fell by 22.9% to $168 million, as earnings per share fell three cents compared to last year, coming in at $0.14 per share. Consensus estimates for GAAP earnings stood at $0.17 per share.

Non-GAAP earnings came in at $0.18 per share which compares to second quarter earnings of $0.16 per share and earnings of $0.24 per share last year.

CEO and Chairman Mike Splinter commented on the developments within Applied's markets, "Consumers' appetite for mobile devices and larger TVs is driving healthy demand for our semiconductor and display equipment. We are seeing stronger investment by our memory customers, and our display business booked its highest orders in over two years."

Looking Into The Results

The Silicon Systems Group took in $1.20 billion in orders, down 22% on the year before. Sales fell 1% to $1.27 billion, resulting in a book-to-bill ratio of 0.94. GAAP operating earnings came in at $246 million, or 19.3% of total sales.

The Applied Global Service unit took in $517 million in orders , for a book-to-bill ratio of 1.04. Sales fell by 4% to $497 million while GAAP operating income was flat at $114 million, or 22.9% of total sales.

Display orders rose by 31% to $256 million as the unit is Applied's bright spot. Sales rose by 27% to $161 million. With a book-to-bill ratio of an impressive 1.59, the future continues to look promising for the unit. Operating income totaled $33 million, or 20.5% of total sales.

The ailing Energy and Environmental Solutions unit took in $19 million in orders, down 51% on the year before. Sales rose by 18% to $45 million. Despite the uptick in sales the unit reported a GAAP operating loss of $27 million.

The total backlog at the end of the quarter stood at $2.29 billion, or little over a quarter worth of revenues. On a positive note, Applied cut is general & administrative costs by $40 million compared to a year ago and channeled $25 million to boost research & development efforts.

Looking Into The Final Quarter

For the current fourth quarter, Applied Materials expects sales to come in flat from the third quarter. Note that this will be a notable improvement from last year's fourth quarter, when sales came in around $1.65 billion. Still, the outlook for flat sales missed estimates of $2.16 billion by a wide margin.

Non-GAAP earnings per share are seen between $0.16 and $0.20 per share. GAAP earnings will be impacted by known acquisition charges totaling $19 million, or $0.04 per share, but could be impacted by other charges which may arise during the quarter.

The earnings outlook fell again short of analysts expectations, with consensus earnings standing at $0.21 per share.

Valuation

Applied Materials ended its third quarter with $3.03 billion in cash, equivalents and short term investments. The company operates with $1.95 billion in long term debt, for a net cash position approaching $1.1 billion.

Revenues for the first nine months of Applied Material's fiscal year of 2013 came in at $5.52 billion, down 21.9% on the year before. Net income was decimated, falling from $624 million to just $73 million on the back of restructuring and impairment charges.

At the current pace, full year revenues are seen around $7.5 billion on which the company could squeeze out a modest profit.

Trading around $15.50 per share, the market values Applied at around $18.7 billion. This values the company's operating assets at $17.6 billion. Operating assets are valued around 2.3 times annual revenues and a non-meaningful profit multiple.

Applied Materials currently pays a quarterly dividend of $0.10 per share, for an annual dividend yield of 2.6%.

Some Historical Perspective

Long term investors in Applied have seen poor returns. Shares set all time highs around $55 per share amidst the internet bubble in 2000. From there onwards, shares kept losing terrain and have traded in a $10-$15 trading range since 2009.

After witnessing year to date returns of almost 40%, shares are now trading at the high-end of the range, with shares exchanging hands around $15.50 per share.

Between 2009 and 2012, Applied Materials has grown its annual revenues by a cumulative 74% to $8.7 billion. The company has turned losses from 2009 into multi-billion profits in its fiscal 2011, before earnings evaporated last year.

Investment Thesis

Investors were pleased with all the announcements despite the soft results and guidance. Applied has named Gary Dickerson to become its new CEO in September, thereby replacing Mike Splinter which will remain Chairman.

Investors react favorably to the management changes. Dickerson joined Applied when the company acquired Varian Semiconductor in 2011. His efforts are already seen as Applied has increased the pace of change, embarked on cost cutting and increased R&D spending.

Applied Materials remains incredibly geared towards Asia as it generates over 70% of its sales from Japan, Korea, China, Taiwan and the rest of the continent. US revenues account for merely 18% of total sales, while European revenues make up just 9% of the total.

The company now employs almost a 1,000 employees fewer compared to last year as Applied has cut severely in operating and overhead expenses. Yet Applied has re-invested a great deal of these savings, some $170 million since the start of the year by increasing funding for the 300 millimeter R&D efforts.

While the continued slump in the personal computer market continues to impact Applied's current earnings, the future looks brighter. At the current rate, Applied is generating annual earnings of around $750 million, excluding restructuring charges. Factoring in growth in 2014, containment of expenses and a more robust pipeline, future earnings could easily come back at a level exceeding $1 billion per annum.

Note that the short term outlook remains soft as foundries, chip producers which work on a contract basis, have cancelled or cut back on short term orders. With a highly concentrated and lumpy customer base these fluctuations on a quarterly basis are inevitable.

The management change is key, and investors applaud the company's move by sending its shares higher despite a tougher than anticipated outlook for the current quarter. Besides the increased velocity of change, cost cutting and increased research and development efforts, other beneficial trends remain at work.

The display orders unit starts to make a meaningful contribution to top-line revenue growth and actual earnings. With a very solid book-to bill ratio of 1.59, and total order share of around 13%, the contributions really start to kick in. Also positive is that losses at the energy and environmental solutions business continue to diminish and should not result in very large unexpected future write-downs.

All in all, earnings should improve to a run-rate exceeding $250 million per quarter next year, or around $1 billion per year. Yet at 17 times annual earnings, shares do not come excessively cheap. On the positive side, Applied is not hesitant to pay out large portions of its earnings in terms of dividend. Current buyers receive a cool 2.6% yield going forward, providing support for the current share price.

I remain cautiously optimistic for the long term, especially after recent management changes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.