Applied Materials: The Merger With Tokyo Electron Won't Make It Less Pricey

| About: Applied Materials, (AMAT)

Applied Materials, Inc. (NASDAQ:AMAT) provides manufacturing equipment, services and software to the global semiconductor, flat panel display, solar photovoltaic, and related industries. Management of the firms expects the merger between AMAT and Tokyo Electron (OTCPK:TOELY) to close in the second half of 2014. The merger is forecasted to result in improved profitability gained from synergies, which are partly attributable to scale advantages.

AMAT's financial results improved recently on higher net sales and better expense discipline. The second quarter results could extend the streak of improved financial performance. In terms of the second half, the combined AMAT/Tokyo could initially be a little light on profitability, but the capital return program is attractive.

Overall, the long-term outlook appears favorable. But the estimated 3.5 times book value price of the merged companies is a little bit on the pricey side. Below 3.25 times book appears to be a bargain.

Recent Development

  1. The DOJ is probing the planned merger of Tokyo Electron and AMAT.
  2. Samsung (OTC:SSNLF) guided for its 2014 chip capital expenditure to be flat Y/Y. Intel (NASDAQ:INTC) and TSMC (NYSE:TSM) also guided to flat capital expenditure for this year.
  3. AMAT was cut to Sector Perform by RBC Capital.

Business Summary

Applied Materials is the world's largest supplier of semiconductor manufacturing equipment. The firm's systems are used in the chemical vapor deposition, physical vapor deposition, and electroplating steps of the chip-fabrication process. AMAT also supplies etching, chemical mechanical polishing and wafer- and reticle-inspection systems; as well as critical dimension measurement and defect-inspection scanning electron microscopes.

AMAT is the chip equipment industry's standard bearer. The firm has the broadest product portfolio and offers customers the closest thing to a one-stop shop. The organization has benefited from the rising popularity of flat-panel displays, which have been a driver of growth for the firm and share manufacturing technologies with those used in semiconductor fabrication. But AMAT must compete successfully in various segments with numerous firms that specialize in their submarkets; consequently, AMAT may not have the best-of-breed product in every segment in which it competes.

Cash flow from operations increased substantially in the first quarter relative to the year-ago quarter. The change in CFO is mostly attributable to higher net sales and profit margin expansion, which resulted in higher net income for the quarter. Additionally, the net change in operating assets and liabilities resulted in a cash inflow during 2014's fiscal first quarter. Cash provided by operating activities totaled $372M and free cash flow-to-the firm was $324M.

The quality of earnings, on a cash flows basis, improved during the fiscal first quarter relative to 2013's fiscal fourth quarter as working capital provided cash in the fiscal first quarter whereas working capital used cash in the fiscal fourth quarter. The earnings quality from the balance sheet prospective is inline with the cash flows basis earnings quality.

For the fiscal second quarter, management is forecasting net sales in the $2.26B to $2.41B range. In my opinion, the implied GAAP diluted EPS forecast is $0.22 to $0.26.

The merger of AMAT and Tokyo Electron is estimated to create a company with total industry share of 25.5% (2012), according to Gartner, which is roughly twice that of ASML's 2012 12.8% market share. The combined company is expected to have an operating margin north of 20%.

These are rough estimates of what the combined company would look like following the closing of the merger. The annual sales would be roughly $14B with operating income of $1.47B and net income of about $667M. The combined book value of equity would be $13.3B. There would be 1.61B shares outstanding with management planning to repurchase $3B of shares in the first 12 months.

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If management can achieve the envisioned profitability, then the combined companies would be more likely to deserve a premium valuation.


  1. The share price is likely to remain volatile and investors could lose a portion or all of their investment.
  2. Investors should judge the suitability of an investment in AMAT in light of their own unique circumstances.
  3. A decline in the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
  4. The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
  5. Competition in product development and pricing could adversely impact performance.
  6. Incorrect forecasts of customer demand could adversely impact the results of operations.
  7. Higher interest rates may reduce demand for AMAT's offerings and negatively impact the results of operations and the share price.
  8. The Tokyo Electron merger may not close as expected or the combined companies may underperform forecasts.

This section does not discuss all risks related to an investment in AMAT.

Portfolio & Valuation

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AMAT is in a bull market of primary and intermediate-term degree following an intermediate-term correction. Investors are visibly accumulating shares as evidenced by the accumulation/distribution line. Resistance could be in the $20-$25 per share range.

The organization's share price is strongly correlated with the share price of the S&P 500. Since 2013, the correlation is 0.95. And since 2009, the correlation is 0.79. Additionally, variations of the share price of the S&P 500 explain a significant amount of the variations of the share price of AMAT. Thus, forecasts for the share price of AMAT should include forecasts for the share price of SPY.

The shares are trading above the long-term linear trend. The 3-months, 6-months, and 9-months price targets are $15.10, $15.35, and $15.85. This hints at an upcoming period of consolidation.

The combined companies are forecasted to trade at about 3.5 times book and about 2 times sales. AMAT/Tokyo would trade at about 30, if not more, times earnings. Thinking about the long term forecasted financials, the valuation makes sense. Also, the combined company would be the industry leader. But on the other hand, the near term forecasted fundamentals would suggest the combined firm would be a little bit on the pricey side. The accumulation zone, in my opinion, is 20-30% above the market's P/B, which currently is slightly lower than 3.5 times book.

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.