The semi-conductor industry as a whole has had a rough nine months. First, it absorbed a one-two punch during 2011, with natural disasters such as the Thai flooding adding to the pain and disruption caused by the European debt crisis and general economic slowdown. Then, after a spring of better-than-expected demand and rising share prices, the recent stock market correction went and erased all of the gains for the year.
Shares of Applied Materials (AMAT), the largest semiconductor equipment supplier by revenue, have felt this pain more than most. Over the past 200 days, Applied's shares have underperformed the Philadelphia Semiconductor Index by over 11% (see chart) and have underperformed the S&P 500 by almost 20%.
However, things may be starting to turn around for Applied. Business conditions look set to improve into the second half of the year and the stock is currently trading near levels that have provided major support over the past 10 years. What is more, Applied is also currently trading, across several metrics, at significant discounts to its industry and to its own longer-term valuation averages and has a prospective dividend yield of 3.4%. While shares may decline in the short-run, I believe that attractive valuation levels may provide a sizable margin of safety for entering long-term investments between $10-$11/share or below.
This research brief will walk through Applied's business, industry dynamics, financial results and valuation, as well as discussing the current technical picture for its shares.
Business Description and Industry Dynamics
Business Description: Applied Materials is the world's largest semi-conductor fabrication equipment supplier by revenue.
Its revenues of $9.7 billion over the 12 months ending in its most recent FY2012 quarter (Q2, ending April 29th, 2012) were more than three times those of its leading U.S. competitors by revenue, KLA-Tencor (KLAC) ($3.2 billion) and Lam Research Corporation (LRCX) ($2.7 billion). For the 12 months ending December 2011/January 2012, AMAT's $10.02 billion in revenue was over 20% higher than the US$8.1 billion in revenue of its closest competitor, Tokyo Electron (OTCPK:TOELF) (revenue converted at average JPY rate for Jan-Dec 2011).
Applied, which was founded in 1967 in Mountain View, CA, operates in four segments:
- Silicon Systems - Applied develops, manufactures and sells a wide range of equipment used in all aspects of fabrication of integrated circuits (semiconductors), including deposition (depositing layers of films on a wafer), etch (selectively removing material from wafer surface), rapid thermal processing (annealing, or modifying properties of deposited films), surface preparation, metrology and wafer inspection, mask making and, with the acquisition of Varian Semiconductor Associates in November 2011, ion implantation, which is used in the manufacture of transistors, the basic building blocks of integrated circuits.
- Applied Global Services - Applied bases, on or near fabrication sites, engineers who service Applied's installed base of over 37,000 installed tools, as well as non-Applied systems. Their mission is to improve the performance and productivity of the systems and reduce the environmental impact of the fabrication operations of semiconductor, LCD and solar photovoltaic manufacturers.
- Display - Applied develops, manufactures and sells products for manufacturing LCDs, organic light-emitting diodes, and other display technologies for TVs, personal computers, tablets, smart phones, and other consumer-oriented devices.
- Energy and Environmental Solutions (E.E.S.) - Applied is the leading global supplier of products for fabricating solar photovoltaic cells and modules. Applied also develops products for high throughput roll-to-roll coating systems for flexible electronics and web products and systems used in the manufacture of energy-efficient glass.
During the first two quarters of FY 2012 (ending April 29th, 2012), Applied derived 66% of its revenue from its Silicon Systems division, up from 53% in the first six months of 2011. Global Services accounted for 23% of the business, up from 21% in the previous year period. By contrast, Display and Energy and Environmental Services together accounted for only 11%, down from 26% in the first half of FY 2011, driven by a cyclical downturn in those industries. The relative increases in Silicon Systems and Applied Global Services at the expense of Display and E.E.S. were driven by both the acquisition of Varian - which added $535 million in net sales in the first six months of FY 2012 - and the downturn in those segments, with revenue falling a combined $894 million from the 2011 period. In May, Applied announced plans to restructure the E.E.S. division to reduce its cost structure and make it profitable at lower revenue points.
Industry Dynamics: Given its dominant market share and the expansion of Silicon Systems as a percentage of its business, Applied is very leveraged to semiconductor industry demand, capacity growth and capacity utilization. After an extremely strong in 2010, 2011 saw anemic growth as capacity expansion plateaued and utilization faded by about 7% due to the weak economy and shocks such as the Japan earthquake and the Thai floods.
Total integrated circuit (IC) capacity, according to the Semiconductor Industry Capacity Statistics program and SemiconductorIntelligence.com calculations, recovered to around 2.2 million 8" equivalent wafers per week in Q4 2011, near its highs from Q3 2008 (see chart from SemiconductorIntelligence.com).
Concurrently, after metal oxide semiconductor integrated circuit (MOS IC) capacity utilization dropped to under 60% during the first quarter of 2009, it recovered sharply through the second quarter of 2010 to 96% before plateauing and fading to 88% in the fourth quarter of 2011, driven by the Thai floods and the weak economy. (see chart from SemiconductorIntelligence.com).
The net effect was a weak second half of 2011, followed by relatively low growth in the first half of 2012. However, semiconductor equipment bookings picked up in the fourth quarter of 2011 and bookings and billings look set to expand into the second half of 2012 based on recent guidance from semi-conductor manufacturers on their capital expansion plans (see table from SemiconductorIntelligence.com).
This potential cyclical upturn, plus the ongoing secular trend toward larger wafers (450mm vs 300mm), smaller chip sizes and more complex chip construction bode well for demand in the semiconductor equipment industry. Indeed, a recent article by Morningstar highlighted the current shortage in 28nm chips, used extensively in cell phones, and predicted that "capacity constraints in the 28 nm process could result in an additional $3 billion-$4 billion in foundry wafer fab equipment spending" in 2012, over and above the $30-$35 billion forecast by Applied and other industry leaders. Given Applied's roughly 20% market share, this could result in $600 - $800 million additional 2012 revenue.
These trends also play to Applied's strengths as a company. As the largest supplier in the market and a significant services provider, Applied can offer all needed tools and processes, as well as services, which is attractive to producers who need to shift gears on a tight timeline. Its competitors, other than Tokyo Electron, have mainly been specialists in a certain segment of the process. For instance, KLA-Tencor is a specialist in quality control segments, Lam Research in the etch-and-clean segment and Novellus (NVLS) in the deposition and strip segments. Lam and Novellus recent announced a merger which will allow them to provide a more integrated offering, along the lines of Applied or Tokyo Electron. However, their combined revenues will only be about $4.4 billion and their 2011 R&D budget of $560 million was no match for Applied's $1.12 billion. Applied's mastery of all aspects of the fabrication process and its sheer scale, in terms of its R&D budget and the engineers that it has on-site in all of the world's fabrication plants, position it well for the increasingly complex chip fabrication environment (450mm wafers, 28 nm and smaller chips, 3D fabrication, etc) and to continue to expand into adjacent markets such as display and environmental.
Financial Results and Valuation
Revenue and Profitability: Applied's revenue is cyclical and primarily driven by trends in semiconductor bookings and billings, cratering in 2002-03 (revenue of around $5 billion and operating margin of -7%) and then recovering amid subsequent recoveries to the $9 billion - $10 billion range and operating margins of around 20%.
Four quarter rolling revenue has declined from a peak of $11.2 billion in the four quarters ending July 2011 to $9.7 billion in the four quarters ending April 2012, during which operating margins declined from 24% to 17% and net margins from 17% to 14%. Part of the decline in operating and net margins is due to $222 million in inventory valuation adjustments, amortization of purchased receivables and other costs associated with the Varian acquisition. Removing the charges, Applied would have achieved a 19.2% operating margin and 15.4% net margin, consistent with recent history.
Rather than a prelude to a 2009-style collapse, I believe the recent decline in revenue and margins represents a mid-cycle slowdown that will be remedied through increased capital spending by foundries, reflected in improving new orders at Applied and semiconductor equipment bookings industry-wide. Indeed, management forecasts full year (FY ends in October) revenue at the high end of a $9.1 billion - $9.5 billion; with the expansion of 28 nm capacity, it is foreseeable that full year revenue could beat expectations.
Financial Strength: Applied's balance sheet is designed to withstand the cyclical nature of the industry. Its debt to equity ratio, which had been averaging 2-3% for several years, did jump to 22.8% in the quarter ending July 2011 as Applied issued $1.75 billion in senior unsecured notes to help finance the $4.2 billion acquisition of Varian. However, even with the increase in debt, Applied still has modest financial leverage - assets-to-equity ratio of 1.6 - its $2.5 billion of cash can cover 81% of current liabilities, and it has a current ratio of 2.4.
Earnings Quality: Applied's Days-of-Sales Outstanding, which shows Applied's effectiveness in collecting its receivables, has remained very steady over the past 10 quarters. DSO was 63.2 days in the quarter ending April 29th, 2012, steady versus a 10 quarter average of 61.2 days and down from a 10 year average of 74.3 days. On the whole, Applied had an accruals ratio of -1.4% in the second quarter of 2012 and has a history of very small negative or positive changes in accruals. Both the steady-to-improving DSO and accrual ratios are consistent with what I believe to be conservative and appropriate revenue recognition policies reported by Applied.
With respect to expenses, Applied does have a history of taking inventory valuation, restructuring and acquisition-related charges and then later revising their assumptions and releasing positive adjustments back into earnings. They did this with the workforce restructuring plan they announced in November 2009 and the first restructuring of the Energy and Environmental Services segment in July 2010 and will likely be recording a second restructuring charge in the amount of $70-$100 million in the third quarter of FY 2012 related to their announced, second E.E.S. restructuring. While I would rather see Applied simply record some of these expenses as they occur - as a normal cost of doing business - the amounts involved are minor compared to their revenues and income and this practice does not alter my positive view of the company or its accounting practices.
Valuation: Applied is currently trading at a trailing-twelve-month P/E ratio of 10.1, well below its previous cycle range of 14.5 to 24 and also below the 14 P/E valuation given to Novellus in its recent $3.3 billion acquisition by Lam Research. Applied's Price/Book (1.5x), Price/Cash Flow (6.5x) and Price/Sales (1.4x) ratios are similarly well below their longer term averages.
Depressed valuations imply strong discounting of current revenues and profitability due to expectations of renewed cyclical economic decline. But, when I look at 10-year averages for revenue, book equity, earnings and operating cash flow, as well as average multiples to those, I calculate indicative share prices between $11.30 and $26.54 with an average of $18.53 (see table below), implying a margin of safety with respect to Applied's current $10.61 share price.
Applied's projected dividend yield of 3.4%, well above its 5-year average of 2%, implies a margin of safety as well. They have increased or held constant their dividends per share over the past seven fiscal years, since first declaring a dividend in 2005, achieving 5 year compound dividend growth of 13.4% ($0.16/share in FY2006 to $0.30/share in FY2011). Applied still has considerable room to increase its dividend, with a payout ratio of only around 31.5% of net income. Indeed, Applied's declared dividends in FY 2012 are up almost 15% from the 2011 period, faster than their long-term average.
Conclusion - Buy AMAT below $11.00/share (And Especially on Dips to $10.00/share): I believe that Applied Materials' financial strength, expanding product offering, attractive valuation and high dividend yield, in the context of expanding demand in the industry, bode well for AMAT shares. Technically, the picture seems to be improving as well, making this a potentially attractive entry point.
Historically, the $10.00-$10.50/share range has been an excellent area to enter long-term positions in AMAT. Over the past 10 years, AMAT has made significant bottoms around the $10.00/share level, immediately followed by 20%-130% rallies, on six occasions, and may be doing the same right now (see chart).
Also, AMAT shares have underperformed the S&P 500 by over 18% over the past year. Over the past 10 years, one-year relative performance has had a -0.46 correlation with future one-year AMAT absolute total returns, suggesting that AMAT could experience strong returns over the next year (see chart). And, the correlation has been relatively stable, with 3-year rolling correlations ranging between -0.40 and -0.80 since 2002.
For these reasons, for investors with a long-term focus and the ability to withstand short-term volatility, I would recommend purchasing AMAT shares below $11/share and especially on dips to long-term support at $10/share.
Disclaimer: Bard Luippold is Corporate Finance Manager for Meracord LLC ("Meracord"). This article is prepared by Mr. Luippold as an outside business activity. As such, Meracord does not review or approve materials presented herein. The opinions and any recommendations expressed in this article are those of the author and do not reflect the opinions or recommendations of Meracord.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results.