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On Tuesday Applied Materials (AMAT) announced a transformational acquisition of Japanese Tokyo Electron. While both companies are trying to convince the market that the deal is a merger, in reality it seems like a takeover of the Japanese firm.

Investors are applauding the consolidation within the industry which has suffered from suboptimal profitability recently. Expected synergies in this "defensive" deal are driven by costs cuts, allowing Applied Materials to restore suboptimal profitability.

Yet I remain cautious given the cultural integration challenges and lack of earnings at Tokyo Electron. This might result in a bumpy integration road in the year's ahead, despite the sizable synergy estimates.

The Deal

Applied Materials announced that it has entered into a definitive agreement to combine its operations with Tokyo Electron Limited.

While the deal is presented as a merger of equals, it is really an acquisition made by Applied Materials. The all-stock deal will create a huge semiconductor and display manufacturing technology with combined value of around $29 billion.

Under terms of the deal, shareholders in Tokyo Electron will receive 3.25 new shares in the company for every share they own, while Applied's shareholders stand to receive 1 new share in the new combination. As a result, shareholders in Applied Materials will hold a combined 68% stake in the company, with the remainder of shares being held by shareholders in Tokyo Electron.

The deal brings two companies together with complementary technologies and products, and increases the capabilities for precision material engineering. The focus is on advancing roadmaps in semiconductor and display technology, supplying global consumers with the next generation of amazing electronic devices.

The company will maintain headquarters in Santa Clara and Tokyo, and will, most likely for tax reasons, be incorporated in the Netherlands. Tersuro Higashi will be the chairman of the new company, while Applied's current CEO Dickerson will remain in that role in the new company, overseeing some 27,000 workers. The board will consist of 11 directors, with five representatives from each company and one "neutral" director.

CEO Dickerson only replaced former executive Mike Splinter a short while ago. This deal is a clear statement in his intentions to consolidate the industry as poor PC sales and modest growth in general semiconductor demand is taking a toll on Applied Materials.

Both companies see an annualized run-rate of operating synergies of around $250 million by end of the first year after the deal has closed. These synergies should increase toward $500 million per annum in the third year after closure.

A new $3 billion stock repurchase program should be completed within twelve months after closing, resulting in an accretive EPS deal in the first year after closure, although on a non-GAAP basis.

The Boards of both companies have already approved the deal. The deal is furthermore subject to shareholder and regulatory approval, and is expected to close in mid 2014, or in the second half of that year.

Valuation

Applied Materials ended the third quarter with $3.03 billion in cash, equivalents and short-term investment. The company operates with an equivalent debt position of $1.95 billion for a net cash position of around $1.1 billion.

Net sales for the first nine months of the fiscal year of 2013 came in at $5.52 billion, down 21.9% on the year before. Net earnings fell by 88.3% to merely $73 million, driven by $278 million impairment charges in the second quarter, among others.

Full year revenues are seen around $7.5 billion while the company should be able to squeeze out a modest profit.

Factoring in gains of 9%, the market values Applied Materials at $17.50 per share, the firm at $21.0 billion. This values the company at 2.8 times revenues and a non-meaningful profit multiple.

The quarterly dividend of $0.10 per share provides investors with a dividend yield of 2.3%.

Some Historical Perspective

Long-term holders have seen nothing but stagnant returns in Applied Materials. Adjusted for stock splits shares almost hit upon highs of $60 in the year of 2000.

Shares have steadily lost ground to trade as low as $10 in 2008. Ever since, shares have traded in a relative tight $10-$15 trading range, breaking out toward the upside on the back of the deal.

Between 2009 and 2012, Applied increased its annual revenues by a cumulative 74% to $8.72 billion. The company turned a $300 million loss in 2009 into a $1.9 billion profit in 2011, to see earnings fall to a paltry $109 million in 2012. Given the guidance, the results for 2013 will not be great as well, as revenue are set to decline markedly.

Investment Thesis

So while it is presented as a merger of equals, this is really an acquisition of Tokyo Electron by Applied Materials. The company's reported combined revenues of $12.6 billion, of which 57%, or some $7.2 billion was being generated by Applied Materials over the past twelve months. Note that operating income totaled just $0.8 billion for the combination, while trailing net income came in around $0.6 billion. On both metrics, Tokyo Electron was breaking even.

Antitrust issues might arise given the size of the deal. Yet consolidation is outright necessary, something regulators should understand, while it can be beneficial as well. Shares of Micron Technology (MU) have already risen some 170% this year on the back of the acquisition of bankrupt Japanese semiconductor firm Elpida Memory.

So for the immediate future Applied And Tokyo Electron will be a $29 billion valuation company, which has now risen to $31 billion, factoring in the gains in Applied's stock price.

The company generates $12.6 billion in revenues and $0.6 billion in net income. Earnings should advance to $1.1 billion following the expected synergies as the company stands to retire some 10% of its shares outstanding. Still the valuation at $28 billion, once factoring in buybacks, values the company at 2.2 times annual revenues and 25 times annual earnings.

Yet the company sees long-term cost and strategic synergies. By 2017, the company should be able to report annual revenues of $18.2 billion according to the company's presentation, while reported earrings per share of $2.40, imply that earnings should advance to $3.0 billion.

This would bring the valuation down to a more acceptable 1.5 times annual revenues and 9-10 times annual earnings. Note that these targets are still 4 years away, and the target seems a bit ambitious to me.

Yet I agree that the deal makes sense. The $500 million in cost synergies would warrant a valuation of $5 billion for the deal easily. Yet Applied is paying $10 billion for Tokyo Electron, or close to 2 times annual revenues for the firm which is not making money. To make the deal worthwhile, more than $500 million in cost synergies should be achieved. Revenue and strategic synergies would need to be achieved as well in order to enhance performance, battery life and display performance for the next generation of electronics and smartphones.

Back in August, I last took a look at Applied's prospects. The good thing is that Applied generates roughly 70% of its sales from Asia, making the normal cultural integration difficulties between a US and Japanese company probably a bit easier. Applied is in the middle of job cuts which are focused on restoring operating profitability while boosting R&D investments for the future.

I noted that Applied generates annual earnings of around $750 million per annum at the time, on track to exceed the $1 billion mark by 2014. The zero contribution from Tokyo Electron and $500 million in synergies make the $3 billion profit target by 2017 quite a challenge.

I was cautiously optimistic at the time, especially after the management changes by appointing Dickerson as new CEO. The acquisition is a bold move. While the price is cheap on sales multiples, especially as Applied stands to reap most of the benefits, the deal faces quite some integration and cultural challenges. The lack of earnings at Electron is a red flag as well.

I remain on the sidelines given the increased risks in the short to medium term. Yet if Applied manages to fulfill on its 2017 targets during the integration process shares could easily double in the coming five years.

Source: Applied Materials: Hesitant After 'Expensive' Transformational Deal