Applied Materials - Aggressive Earnings Targets Make Me Cautious Despite JPMorgan's Optimism

| About: Applied Materials, (AMAT)


JPMorgan turns bullish on Applied Materials.

Growth, market expansion, market share gains and the Tokyo Electron's deal will all boost future earnings growth.

That being said, I think Applied's long term earnings targets are too aggressive, leaving room for potential disappointments.

Shares of Applied Materials (NASDAQ:AMAT) jumped up on Monday following an upgrade by analysts at JPMorgan. That being said, shares lost most of the gained ground during the trading day as markets were slipping further into the red.

While I do see improvements around the corner for Applied Materials in the coming years, I think the company's own targets are too ambitious making it rather easy for me to avoid JPMorgan's advice and stay on the sidelines.

JPMorgan Turns Bullish

JPMorgan's Harlan Sur has raised the rating on Applied Materials from Neutral to Overweight, while raising the price target by $11 to $30 per share. This would suggest that shares have another 30% upside from current levels.

The bank cites three reasons to be optimistic. This includes the ¨solid¨ position in the semiconductor equipment market. Other drivers are the positive outlook for ¨Moore's Law-driven Wafer¨ equipment and the anticipated completion of the Tokyo Electron acquisition in the second half of this year.

Especially the merger with Tokyo Electron could really boost earnings power for the years of 2016 and 2017. On top of cost savings and opportunities for margin expansion, Sur also anticipates more long-term advantages in terms of the development of next-generation manufacturing technologies. Notably the so-called ¨etch¨ and ¨deposition¨ techniques are two core areas going forwards. Combined with Tokyo Electron, Applied should be able to accelerate the pace of developments in these areas.

7th Of July Presentation

On Monday, Applied Materials held a big investor presentation, outlining the future plans after combining operations with Tokyo Electron.

CEO Gary Dickerson stresses the importance of materials innovation and execution as drivers for Applied's potential. The company stresses the achievements already being made towards its 2016 goals. This includes a 1.4% improvement in WFE market share and 6 sequential quarters of non-GAAP operating margin improvements.

The company furthermore anticipates 25 billion in connected devices by 2020, with data in the universe expected to more than double between 2014 and 2016 to 13 zetabytes. Further growth is anticipated in the year's following.

The WFE (water front-end) market is seen between $30 and $37 billion according to Gartner estimates and assumptions made by Applied Materials itself during the financial part of the presentation. With revenues coming in at the midpoint of this range, and a market share of 20%, the company targets revenues of $10.8 billion.

Note that this outlook does not incorporate the contribution from Tokyo Electron. Operating margins for the stand-alone business are seen by 24% in 2016, which should allow the company to report earnings of $1.70 per share.

To achieve these ambitious targets the focus is on execution, growth in new markets and disruptive products, and a high velocity of new products and capital allocations.

Current Valuation

In May, Applied Materials released its second quarter results, ending the quarter with $3.4 billion in cash, equivalents and marketable securities. Total debt stood at little less than $2 billion resulting in a comfortable net cash position.

On a trailing basis, Applied has posted sales of $8.50 billion on which it has reported earnings of $866 million. At $23 per share, equity is valued at roughly $28 billion currently. This values equity in the business at 3.3 times sales and 32-33 times earnings.

Applied's quarterly dividend of $0.10 per share, provides investors with a 1.7% annual yield.

Future Perspective

Of course the valuation is high based on the current performance of the company. A lot of the share price appreciation is based upon the achievement of both operational improvements, sales growth and the merger with Tokyo Electron. The deal which was announced last year, is expected to close before the end of the year and the implications could be huge.

The $9.4 billion deal which will be financed entirely with shares is expected to create a dominant player in the WFE market. Applied's market share runs about 20% while Tokyo Electron posts a share of about 14%. The more dominant market position should boost pricing power and result in lots of potential cost synergies.

Investors in the Japanese business will receive shares for their holdings, diluting the total outstanding share base to roughly 1.8 billion shares. This implies that Applied's future equity will be valued at $41 billion. To offset some of the dilution, a $3 billion planned repurchase program would reduce the market valuation to about $38 billion based upon current prices.

For 2017, the company anticipates $18 billion in revenues and operating income of about $4.5 billion. Underlying these rosy predictions is a solid growth of the stand-alone operations, anticipated market share growth and an overall growth of the WFE market.

Given the anticipated operating earnings of 25%, the very modest interest bills and low anticipated tax rates thanks to being located in the Netherlands, Applied sees earnings of about $3.5 billion on the bottom line.

Part of this is driven by anticipated synergies of $500 million, and the current profitability of notably Applied Materials, with Tokyo Electron struggling to post GAAP earnings. Even then, the assumptions underlying this earnings forecast are quite aggressive.

Final Takeaway

If Applied can achieve its 2017 targets, shares arguably offer appeal at roughly 11 times anticipated earnings amidst a very solid balance sheet.

Yet it should be noted a lot of work and progress is required to achieve these targets. Even when adding annual synergies of $500 million on the current run rate of Applied's earnings of about a billion, much progress is required.

This is especially the case given that Tokyo Electron is still not reporting any earnings at this point in time. This would imply that the achievement of targets relies heavily on improved operational performance, market growth and market share gains.

In my eyes, the outlined targets are very impressive and I see a great chance of Applied not being able to achieve the targets given the ambitious nature.

Back in May, I last checked out the prospects for the company in the wake of the earnings release, with shares trading around $20 at the time. I noted that investors were pleased with improvements in the results and a 10-20% full year growth forecast. Yet investors have already reflected on a lot of good news with shares currently trading up 30% so far in 2014.

Given the ambitious nature of the anticipated synergies and earnings progress into 2016-2017, I think it might be quite likely that the company will fail to meet its earnings targets in the future. As such, I remain on the sidelines, not sharing JPMorgan's optimism.

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