Applied Materials Earnings Preview: Cheap For A Reason

| About: Applied Materials, (AMAT)

Although Applied Materials (NASDAQ:AMAT) could be overshadowed by Cisco (NASDAQ:CSCO) Wednesday night, Applied Materials is also expected to release its fiscal 3rd quarter, 2012, earnings report after the bell, with analyst consensus expecting $0.22 in earnings per share on $2.32 billion in revenue for expected year-over-year declines of 37% and 17% respectively.

In early July, AMAT warned that the current quarter's results would come in closer to the low end of revenue guidance given in the May earnings release, which has resulted in downward revisions to earnings and revenue estimates, from $0.25 in earnings per share and $2.439 billion to the current consensus.

One bookings estimate we saw from a Street analyst expected bookings of $2.09 billion in the fiscal 3rd quarter.

That being said, the stock today is trading above where the warning was made in early July, and also above its 200-day moving average.

We've followed AMAT for years, since the late 1990s, when it was one of the bubble babies from the tech bubble, but today it is far closer to a value stock than a growth stock.

By division, AMAT has 4 primary segments, with the Silicon Systems Group (SSG) accounting for 70% of revenue and all of AMAT's operating income last quarter, as the other three segments are awash in a sea of red ink.

According to a research report out of Credit Suisse, in a preview of AMAT's earnings report, two of AMAT's main competitors, LAM Research and ASML reported revenues +10% and -10% respectively recently, so expectations are pretty depressed coming into the report.

Here is a quick look at AMAT's current valuation, using the current stock price, current consensus estimates and cash-flow and balance sheet data as of the April quarter:

2012 p/e ratio: 15(x)

2013 p/e ratio: 12(x)

expected earnings growth: -40% for 2012 and +23% in 2013

Price to cash-flow 7(x)

Price to free-cash-flow 7.25(x)

free-cash-flow yield: 12%

Price to sales: 1.5(x)

Dividend yield 2.5%

Technically, the semiconductor segment is acting better through this tough summer, and as we approach the better seasonal period for trading tech and semiconductors, which is the fall and winter periods. However AMAT could be cheap for a reason, as the push into Solar in the middle part of the last decade does not look too great in hindsight.

Most Street estimates have a fair value or intrinsic value estimate for AMAT in the high teens, low $20s, so the stock appears to be trading at a steep discount to fair value, but this is a highly leveraged business with very onerous reinvestment constraints (capex is over 20% of revenue for most of the last 10 years), which puts severe pressure on returns, and is one reason we believe semi's have struggled the last 10 - 12 years.

However, AMAT is a better buy with gross margins closer to 40% (42% as of the May quarter) and sold when the gross margin moves closer to 50%.

Be patient with AMAT: we like the free-cash-flow and free-cash flow yield, but right now the stock is cheap for a reason. The semiconductors are a very cyclical group, and with the cycle looking closer to a bottom than a top, the global growth slowdown does not bode well for businesses requiring a heavy reinvestment cycle as semiconductors do.

Disclosure: I am long AMAT.