Applied Materials - No Surprises As The Long Term Risk-Reward Remains Challenged

| About: Applied Materials, (AMAT)


Applied Materials posted solid results and issues an in-line guidance.

The valuation and this year's momentum relies heavily on the much anticipated closure of the Tokyo Electron deal.

The long term guidance relies heavily on long term aggressive operating margin targets, creating a not so favorable risk-reward opportunity in my eyes.

Applied Materials (NASDAQ:AMAT) reported solid results for the third quarter as the earnings and guidance was largely in line with expectations for the investment community.

Yet all eyes remain on the future and the anticipated closure of last year's announced deal with Tokyo Electron (OTCPK:TOELF), which should create a much stronger market positioning. This could allow the company to make huge incremental gains in profitability in the future.

As management has promised big time, expectations have risen and real improvements following the deal closure are required to drive appeal. Given the huge promises and the uncertain roadmap of achieving them, I remain a bit more cautious. This is also after taking into account this year's momentum already.

Main Third Quarter Results

Applied Materials posted sales of $2.27 billion for the third quarter of this year. While sales were up by 14.7% on an annual basis, reported sales were down by 3.7% on a sequential basis. Analysts expected sales to top $2.29 billion for the quarter.

The company showed real operating strength and cost control as it posted GAAP earnings of $301 million. Earnings were up 79% compared to last year and were up by nearly 15% on a sequential basis despite the drop in sales.

On a diluted basis, earnings came in at $0.24 per share which was a ten cent improvement compared to last year. On a non-GAAP metric, earnings came in at $0.28 per share, which was a penny above consensus estimates.

Looking Into The Numbers

Short term momentum for the company's chips appears to be soft, although the order intake remains comfortably above last year's levels.

The order intake of $2.48 billion results in a solid book-to-bill ratio of 1.09 times, as orders jumped 24% on an annual basis despite being down by 6% on a sequential basis.

Reported gross margins totaled 43.8% of sales, up 130 basis points on a sequential basis, and up 300 basis points compared to last year. The company was very disciplined in its operating expenses, boosting operating income to $391 million.

Operating earnings jumped towards 17.3% of sales, being up 80 basis points on a sequential basis and up 460 basis points on the year. It should be noted that net earnings enjoyed an additional boost from low effective tax rates of just 18.6% for the quarter.

A Quick Look At The Divisions

The overall order intake was very healthy, especially in relationship to current sales, adding to the company's backlog which rose to nearly $3 billion, providing greater visibility to the future performance.

The Silicon Systems Group took in orders worth $1.56 billion after posting sales of $1.48 billion for the quarter which was up by 16% compared to last year. While annual growth was still solid, orders and sales fell by 6 and 7% compared to the first quarter, respectively. Weaker momentum in DRAM was one of the reasons behind the fall.

Orders for the Applied Global Services unit totaled $552 million, a nearly 7% improvement compared to last year and a slight improvement from the first quarter. The book-to-bill ratio fell to 0.97 given the higher sales rates this past quarter.

Display remains the company's largest growth business, yet orders of $296 million fell sharply compared to $340 million in the second quarter. The book-to-bill ratio of nearly 2.50 remains impressive with sales totaling just $119 million for the quarter. Sales were actually down on both an annual and sequential basis. The company did not specify why sales were falling despite the strong order intake and very big backlog.

At last, orders for the historically troubled Energy and Environmental Solutions business fell to $66 million which compares to a paltry $19 million in order intake last year. Sales rose both on a sequential and annual basis to $103 million as the company has posted solid operating earnings, partially driven by litigation income.

The Fourth Quarter Guidance

Sales for the current quarter are seen roughly flat compared to the past third quarter, plus or minus a 3% margin. This translates into year-on-year sales growth of 10-17% being anticipated.

Non-GAAP earnings are seen between $0.25 and $0.29 per share, largely in line with earnings of $0.28 per share as reported in the third quarter. Analysts anticipate non-GAAP earnings of $0.26 per share for the final quarter of the year.

The company has already identified costs of $0.03 per share which will impact GAAP earnings, not being factored into the non-GAAP earnings metrics guidance.

Current Valuation

At the end of the quarter, Applied held nearly $2.9 billion in cash, equivalents and short term investments. Given the nearly $2.0 billion in debt being outstanding, this results in a comfortable net cash position of about a billion dollars.

At the moment, the 1.2 billion shares outstanding value Applied at close to $26 billion excluding the dilutive impact from the Tokyo Electron deal. Applied has now posted trailing revenues of $8.8 billion and earnings of a billion, valuing the business at roughly 3 times sales and 25 times earnings after backing out the net cash position.

Of course investors are looking at the forward valuation after the anticipated ¨acquisition¨ Tokyo Electron to gauge whether the current valuation offers appeal.

What's The Future Implications?

CEO Gary Dickerson is happy with the continued improvements in operating margins, with the past quarter marking the 7th quarter in a row in which margins have improved.

The results are largely in line with expectations as the guidance does not contain major surprises either. Comforting as well is the continued growth foreseen into 2015, driven by new smartphone models in part.

Back in July, I last had a look at Applied's prospects following a big upgrade from analysts at J.P. Morgan. Analysts predicted shares could go as high as $30 per share driven by the solid position in the semiconductor equipment market and the anticipated completion of the deal with Tokyo Electron seen later this year.

This deal could cost the company some $9.4 billion, while it could create a very formidable player in the global WFE market, with analysts and investors betting that the dominant position can result in bigger profits. They are hoping for a replication of the transition made by Micron (NASDAQ:MU) when it bought Elpida in the not too distant past. The all-share deal could result in 1.8 billion shares outstanding, pushing the valuation to $38 billion, or $37 billion after subtracting the billion net cash holding. $3 billion in anticipated share repurchases could reduce this equity valuation towards $34 billion.

The combined company could post sales of $18 billion by 2017 given the growth anticipated in the market. Yet the real value accretion should results in gains in operating earnings with Tokyo posting no real earnings at the moment of the deal announcement, while Applied posted operating margins of 17% of the past quarter. By 2017, the deal should allow these companies to post operating earnings of 25% combined according to comments made by executives in the past. This could result in operating earnings of $4.5 billion which combined with modest interest payments and lower tax rates resulting from being domiciled in The Netherlands, should allow for earnings of $3.5 billion after tax. On those metrics, the current valuation comes down to 10 times anticipated earnings for 2017.

While this is very appealing, the company still has to close the deal and deliver on these huge accretive expectations, which is a big challenge. That being said, Micron has demonstrated that it could become very profitable in a small period of time after displaying a very volatile performance for a long time period. As it lacked dominance in markets for years, it now became a price maker instead of a price taker.

As such I see a lot of potential for the company to miss on these aggressive forecasts, especially in relationship to the current profitability. If the company can deliver on its promises the $30 price target is very realistic. That being said, I don't think the current risk-reward ratio is very appealing, especially after the big run-up of 20% so far despite a recent 10% correction.

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