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Applied Materials, Inc. (AMAT), the semiconductor manufacturing equipment provider, reported fiscal fourth quarter results that topped analysts' expectations. This marked the first quarter of y/y revenues growth in what has been a longstanding trend of declining revenues. This quarter, Applied is expected to post its second consecutive quarter of revenues growth.

AMAT Revenue (Quarterly YoY Growth) Chart

AMAT Revenue (Quarterly YoY Growth) data by YCharts

The financial performance is showing signs of strength as Applied rolls out its 3D chip manufacturing equipment. Also, 450mm wafer fabrication equipment should provide a tailwind. With that said, the inconsistent return on equity and the relatively high cost of equity lead me to the conclusion that Applied is overvalued in the market. I think it should be trading closer to 0.55 times book value.

AMAT Price to Book Value Chart

AMAT Price to Book Value data by YCharts

At 3 times book value, Applied is trading above it 5-year average book value and above my justified P/B. Consequently, although the product pipeline and financial results provide a tailwind, Applied is a short sale candidate as the valuations are stretched given the performance of the business. But I am lacking a catalyst to initiate a short position.

Recent Developments

  • Fiscal fourth-quarter profit of $183 million, or 15 cents per share, compared with a loss of $515 million, or 42 cents a share, for the year-earlier period. Revenue rose to $1.99 billion from $1.65 billion. Adjusted profit was 19 cents a share. Analysts polled by FactSet on average were expecting EPS of 18 cents, on revenue of $1.98 billion.
  • On September 24, 2013, Applied entered into an agreement with Tokyo Electron Limited (OTCPK:TOELF), a Japanese corporation and global provider of semiconductor, flat panel display and photovoltaic panel production equipment.

Business Summary

Applied, a Delaware corporation, provides manufacturing equipment, services and software to the global semiconductor, flat panel display, solar photovoltaic and related industries. The company operates in four reportable segments: Silicon Systems Group, Applied Global Services, Display, and Energy and Environmental Solutions.

Since 2011, net sales declined 28.6% with most of the decline attributable to the Energy and Environmental Solutions segments and another portion of the decline attributable to the Silicon Systems Group. The Applied Global Services and Display segments also contributed to the decline in net sales. The Display segment should be a growth segment on compute, and television demand, but the segment represents a small portion of net revenues. One bright spot, new orders increased 5.3% in fiscal 2013.

At the end of fiscal 2013, the cash balance was just under $1.9 billion and the cash ratio was 0.774. Debt-to-equity was 0.275. Goodwill was 27% of total assets. The financial leverage ratio was 1.7. Overall, the solvency and liquidity positions are excellent. FCFF is trending lower and was $426M in fiscal 2013.

Applied utilizes a complex high tech manufacturing process which results in products that require significant capital expenditure from customers; as such, Applied's revenues are strongly correlated with new product introductions. Consequently, Applied is likely to benefit from the roll out of 3D chip manufacturing as the Applied Centura Silvia system is specifically designed for etching small, deep holes for TSV applications. Also, 450mm wafer fabrication equipment should provide a tailwind. I think there is a strong product pipeline heading into fiscal 2014 and 2015.

Taiwan Semiconductor Manufacturing Company Limited (TSM), Samsung Electronics Co., Ltd., and Intel Corporation (INTC) comprised a significant portion, at least 40%, of net sales during fiscal 2013, which may limit the company's pricing power. But, the need for high tech companies to be on the cutting edge is a mitigating factor in the loss of pricing power.

For the current quarter, the company said it expects revenue to rise sequentially by 3% to 10%, or roughly $2.05 billion to $2.19 billion; this would represent a 33.8% increase relative to the prior year. Applied also expects adjusted profit in the range of 20 cents to 24 cents a share. My expectation is for continued growth.

Risks

  • A weak macroeconomic environment would adversely impact Applied's results of operations.
  • The need to continually reduce the total cost of manufacturing system ownership.
  • The change in consumer preference to NAND flash memory is adversely impacting the results of operations.
  • Applied is exposed to the risk of a highly concentrated customer base.

Valuation

In determining a valuation, I decided to use the price/book value ratio because cash flows and earnings tend to be volatile. With that said, the return on equity is lower than the cost of equity; consequently, Applied should be trading at a discount to book value. Currently, Applied is trading at 3 times book value and its 5-year average is 2.1 times book value.

My baseline assumption of a 4.5% sustainable growth rate suggests a justified value of 0.57 times book value. My optimistic assumption of 5% growth suggests a justified value of 0.51, and the pessimistic scenario of 4% growth suggests a justified value of 0.61. The 10-year average revenues growth rate is 5.31.

I think Applied is substantially overvalued. The higher interest rate environment is weighing on the valuation. The capital intensive nature of the business means higher interest rates adversely impact the valuation. Higher interest rates adversely impact profitability and the required return on equity. Applied Materials is a short sale candidate.

Source: Applied Materials Is Substantially Overvalued