5 Reasons That Applied Materials Is a Good Buy

Jul. 4.11 | About: Applied Materials, (AMAT)

By Paul Kutasovic and Panos Mourdoukoutas

Investors who look for solid technology companies to add to their portfolio for the new quarter, should take a close look at Applied Materials (NASDAQ:AMAT). We do believe the stock is a good buy for five reasons:

  1. The company is soon to recover from a temporary setback in its Japanese operations in the aftermath of the March 11 earthquake.

  2. Applied Materials is well positioned to take advantage of the improving industry fundamentals. Applied Materials operates in four segments:

  • The Silicon Systems group develops equipment for the chip fabrication process and accounted for 55% of FY 2010 sales.

  • Global Services provides services to improve the efficiency of semiconductor factories and accounted for 20% of FY 2010 sales.

  • The Display segment develops equipment used to produce flat panel displays and accounted for 9% of FY 2010 sales.

  • Finally, Energy and Environmental services produces equipment used in the production of solar cells and energy efficient glass and accounted for 16% of FY 2010 sales.

The business outlook over the next two to three years is extremely favorable for all four sectors. Over the next few quarters, the display sector may face some pressure due to some overcapacity in the flat screen market. But its longer term prospects are very positive.

  1. Applied Materials has a solid balance sheet with nearly $2.6 billion in cash and only $200 million in long-term debt. On a valuation basis, the stock is relatively cheap, with a low P/E ratio. Based on its projected ROE and retention rate, the long-term sustainable rate of growth in earnings (retention rate times ROE) should be in the range of 12 to 15%. This implies a PEG ratio (based on the current forward P/E ratio) of less than one, indicating a favorable investment opportunity.

Year

Revenue ($ Mil.)

Cashflow per share

Earnings per share

Return on Equity

2010

$9,549

$0.92

$0.70

12.8%

2009

5,014

-0.01

-0.23

NM

2008

8,129

0.93

0.70

12.6%

2007

9,735

1.39

1.20

23.6%

2006

9,167

1.14

0.97

19.5%

2005

6,992

0.91

0.73

13.3%

2004

8,013

0.99

0.78

15.6%

2003

4,477

0.14

-0.09

NM

2002

5,062

0.39

0.16

3.4%

2001

7,343

0.69

0.46

10.5%

Click to enlarge

Source: AMAT Annual Reports

Sales for Applied Materials rose sharply last year from the depressed levels of 2009. First quarter 2011 revenues are now above the prior cyclical peak that occurred in 2007. Further strong increases in sales are likely in both 2011 and 2012. With sales rising sharply and profitability improving (expect ROE to increase to 18% in 2011), strong earning growth is likely in both 2011, and 2012. EPS will be approaching $2 a share in 2012. Applying a multiple of 13 to 2012 earnings of $2 a share, we get a target price of $26 a share.

  1. The high probability of positive earnings surprises over the next few quarters as Applied Materials beats the consensus earnings forecast. Positive earnings surprises are typically associated with upward moves in stock prices and could provide further upside to Applied Materials. For Applied Materials, earnings surprises are likely to come from expanding solar sales. Given the falling cost of production and rapid revenue growth, the Energy and Environmental Solutions segment will be a major contributor to 2011 and 2012 profits.

  2. The company pays a 2.5% dividend—unusually high for technology companies.

Disclosure: We are long AMAT