Applied Materials (AMAT) is one of the largest semiconductor companies in the world. The company provides components primarily to TFT, semiconductor, and solar manufacturing industries. Founded in 1967, AMAT has 13,000 employees and offices in 16 countries spread across North America, the Middle East, Asia, and Europe. AMAT has been the No. 1 supplier of equipment to the Silicon chip making industry since the 1990s. Over time, the company has grown steadily to match the industry demand. The company also has an aggressive growth policy. In the last 15 years, AMAT has acquired Opal Technologies, Orbot Instruments, Etec Systems, Oramir Semiconductor Equipment, Baccini, and, most recently, Varian Semiconductor.
As of Sept. 12, 2012, AMAT stock was trading at $11.65, with a 52-week range of $9.70-$13.94. It has a market cap of $14.5 billion. The trailing 12 months P/E ratio is 14.04 and the forward P/E ratio is 14.38. P/B, P/S, and P/CF ratios stand at 1.7, 1.6, and 7.1, respectively. Its operating margin is 13.7%, whereas net profit margin is 11.7%. The company has minor debt issues as a debt/equity ratio of only 0.2 is far below the market average.
Applied Materials pays stable dividends; trailing yield is 2.96% against a forward yield of 3.24%. However, I expect another dividend raise next year. For 2012, the company has already increased quarterly dividends by 13% to 9 cents. Five-year dividend history suggests that AMAT is a nifty, as well as safe, dividend payer.
Applied Materials has a five-star rating from Morningstar. Out of eight analysts covering the company, three have a "buy" rating, four have a "hold," and one has a "sell." Wall Street clearly has divided opinions regarding the company's future. The average five-year annualized growth forecast estimate is 9%. What is the fair value of Applied Materials given the forecast estimates? We can estimate AMAT's fair value using discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is primary used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of trailing 12 months EPS along with the mean EPS estimate for the next year.
E0 = EPS = ($0.83 + $0.81) / 2 = $0.82
Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 9%. Book value per share is $6.74. The rest is as follows:
Fair Value Estimator
Fair Value Range
(You can download the FED+ Fair Value Estimator here.)
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my five-year discounted-earnings-plus-book-value model, the fair-value range for AMAT is between $11.51 and $18.25 per share. At a price of $11.65, AMAT is trading at the lower end of its fair value range. However, the stock has up to 56% potential to reach its maximum potential.
While there are many companies in the semiconductor equipment and materials industry, KLA-Tencor Corporation (KLAC) is probably the closest competitor of Applied Materials. To assess how much profit companies generate on the money shareholders have invested, we consider return on equity. AMAT has a trailing 12 months ROE of 12.8%, while KLA-Tencor's rate of 24.5% is twice as high. Obviously, KLAC has a pretty strong advantage in terms of profitability. KLAC stock is highly undervalued these days as its stock has at least 43% upside potential to achieve its fair value. Both companies offer stable dividends.
Another competitor, Lam Research Corporation (LRCX), is also a fairly valued stock. However, AMAT's P/E ratio of 14.08 is well below that of LRCX. In contrast to Applied Materials, Lam Research typically does not pay dividends.
The chart below shows AMAT's performance against its main competitors over the last five years:
Click to enlarge image.
AMAT is not the only dividend-growth company that is trading with a fair value. Most dividend-growth stocks are sharing the same faith these days. Based on EPS growth estimate of 9%, the company is trading at a pretty fair price, which is at least 1.5% up on its fair minimum value.
Current Economic Outlook
The semiconductor industry is extremely cyclical and has been trending downwards ever since the second quarter of 2010. Applied Material seems to be severely affected by the industry's downturn, primarily due to its role of a premier supplier to numerous other industry players. The company's sales have continued to decline, and the revenue continued to drop down for the second year in succession.
The company expects net overall sales to decline 25% to 40% further. EPS is expected to fall by $0.06. The industry downturn is attributed to sluggish PC sales as well as the unfavorable macroeconomic conditions. As spending continues to grow, it is expected that the demand for computers will also pick up, improving the environment for AMAT along with its competitors.
Current difficult industry conditions continue to hinder AMAT's progress while its stock price slides down. Its performance in relation to its competitors is also alarming. However, the stock is expected to experience an upturn in its course and is primed for a climb on the stock market.
Nevertheless, based on historical valuation metrics, AMAT stock currently has fairly reasonable price. It is only 1.23% up on its fair value minimum. Thanks to the recent loss of value on the stock market, now would be a very opportunistic time to obtain the AMAT stock. Some insiders have already begun to consider AMAT stock attractive due to its feasible trading price for the returns the company profile more likely promises for the future. As industry upturn is expected soon, cash-rich AMAT could spring a surprise when it does. In this aspect, AMAT stock has high potential to be profitable in the near future Director Parker Gerhard just initiated a new purchase of 50,000 shares in last month. This is another sign that the stock has limited downside potential.