Applied Materials (AMAT) is the world's largest supplier of semiconductor manufacturing equipment.
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Applied Materials stock currently trades at $11.94, with a 52-week range of $9.70 - $15.97. Let's look at the financial results from the last five years:
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Revenue | $9,734 | $8,129 | $5,013 | $9,549 | $10,517 |
| Operating Cash Flow | $2,209 | $1,710 | $332 | $1,723 | $2,426 |
| Capital Expenditure | $-265 | $-288 | $-249 | $-169 | $-209 |
| Free Cash Flow | $1,944 | $1,422 | $84 | $1,554 | $2,217 |
Applied Materials was hit hard in 2009, with revenue down to half of the 2007 value and almost no free cash flow. Since then revenue and cash flow have recovered to pre-recession levels.
Owner Earnings
Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:
These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.
I'll calculate Owner earnings by taking the Net Income and adding back various non-cash items, such as depreciation, and then subtracting the five-year average Capital Expenditures. I'll also add interest payments adjusted for taxes since interest is tax deductible.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Net income | $1,710 | $960 | $-306 | $938 | $1,926 |
| Depreciation & amortization | $268 | $320 | $291 | $305 | $246 |
| Investment/asset impairment charges | $0 | $39 | $240 | $259 | $-30 |
| Stock based compensation | $0 | $178 | $147 | $126 | $146 |
| Other non-cash items | $198 | $37 | $131 | $37 | $-8 |
| Interest Payments | $38 | $20 | $21 | $21 | $59 |
| Avg Capital Expenditure | $-236 | $-236 | $-236 | $-236 | $-236 |
| Owner Earnings | $1,968 | $1,314 | $282 | $1,443 | $2,091 |
Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine Applied Materials' Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which can be a poor measure of profitability.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Owner Earnings | $1,968 | $1,314 | $282 | $1,443 | $2,091 |
| Invested Capital | $10,662 | $11,006 | $9,574 | $10,943 | $13,861 |
| CROIC | 18.46% | 11.95% | 2.95% | 13.19% | 15.09% |
Applied Materials' CROIC was 15% in 2011, off a low of 3% in 2009. Being a highly cyclical company depending on capital expenditures from companies like Intel (INTC) and Taiwan Semiconductor Manufacturing (TSM), consistency in not a guarantee. Here's the most recent balance sheet.
| Cash and Cash Equivalents | $1,997 |
|---|---|
| Investments | $955 |
| Debt | $1,949 |
| Pension Obligations | $0 |
| Minority Interest | $0 |
| Net Cash (Debt) | $1,003 |
| Diluted Float | 1,321 |
| Cash/Share | $0.76 |
Applied Materials has $0.76 in net cash per share, having spent $4.2 billion to acquire Varian Semiconductor in November 2011.
Valuation
I use a discounted cash flow analysis to estimate the fair value of a company. I will use a discount rate of both 12% and 15% and use the results to define a fair value range. You can read about my view on discount rates here. I will assume an owner earnings growth rate of 3%. Using these parameters I arrive at a fair value range of $14.32 - $18.88. Currently trading at $11.94, the market price offers a discount to the lower-end of my fair value range. Below are buy targets for various margins of safety.
| Margin of Safety | Buy Target |
|---|---|
| 10% | $12.92 |
| 15% | $12.20 |
| 20% | $11.48 |
| 25% | $10.76 |
Conclusion
Applied Materials is the largest provider of semiconductor manufacturing equipment and offers over a 15% discount to the lower end of my fair value range. At current prices Applied looks to be a good value.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
