willggh's  Instablog

The market seems to have severely punished most companies related to the PC industry, which everyone seems to bet, is going to be cannibalized by tablets and smartphones. But how bad is it really going to be for the traditional PC (desktop and laptops) industry? The market seems to believe that it's the end for PC's as we know it. I beg to differ. While I do believe that the PC industry is going to decline - maybe significantly so (Yogi Berra would aptly say "The future ain't what it used to be") - I would bet that it's not going to disappear. Most software companies are already focusing on producing apps and operating systems which are adapted for the "cloud" and mobile era. Windows 8, Microsoft Surface, fears on Facebook on being unable to efficiently monetize on mobile users - those are just examples that show how everyone is paranoiacally trying to get a piece of the new era of consumers' IT products, following the lead of companies such as Apple, Qualcomm and ARM Holdings.

All of these changes mean that new hardware solutions will have to be developed and manufactured. It means that the demand for current product lines will decline significantly or become outright obsolete. Some semiconductor companies will adapt and thrive, some will become extinct, and some new competitors will emerge. As a rule of thumb, technological changes tend to affect technology-enabled companies (think Blockbuster vs Netflix) more than they do technology-producers (think Qualcomm).

I think Applied Materials (AMAT) is a good example of a company that might benefit from many of these changes: While AMAT is exposed to the PC industry (and will thus suffer along with many of its semiconductor clients), AMAT is also positioned to profit from these changes, as the semiconductor industry deploys money for badly needed capital expenditures - so as to compete in the manufacturing of more efficient, mobile, and wirelessly connected devices. AMAT is the world's largest supplier of semiconductor manufacturing equipment, meaning it's the single biggest provider for the technology producers.

Business Description

Applied Materials has 4 main business segments:

Silicon Systems Group Segment (51% sales): Equipment and services for use in the front end of the semiconductor fabrication process. Applied offers systems that perform most of the primary processes used in chip fabrication. Clients: integrated device manufacturers and foundries to build and package memory, logic and other types of chips.

- Applied has the industry's largest portfolio of technically advanced products for building smaller and faster transistors, copper-based chips' manufacturing, and low K Insulators, all of which are key to lower energy consumption devices and faster chips, preparing AMAT for the industry's focus on smartphones/tablets/cloud devices.

- Leading innovator of manufacturing equipment for 3D Integrated Circuits (microprocessors), with the potential of drastically reducing power consumption (10-100 times), and the same power in less space. Presently 3D IC is being pursued by major semiconductor companies, but none is actually mass producing chips with this technology.

- Over time, the semiconductor industry has migrated to increasingly larger wafers to build chips. Applied offers a comprehensive range of 300mm systems (currently the biggest standard) and is a leading innovator in 450 mm systems, the future standard.

-Leading portfolio of systems allowing for 22 nm semiconductor manufacturing process. Highest expenditures in R&D in the next manufacturing technologies (14, 10 nm).

- Applied has the biggest systems and tools portfolio in the world, helping semiconductor manufacturers on every step of the manufacturing process.

- Applied profits from technological innovation looking for more energy-efficient chips, as their use become even more prevalent in everyday life. As the cloud pushes for more powerful and energy efficient tablets and smartphones, Applied is researching and innovating equipment and technologies that will enable manufacturers to produce such hardware.

Applied Global Services Segment (23% sales): Products and services designed to improve the performance and productivity of the fab operations of semiconductor, LCD and solar PV manufacturers. Trained customer engineers and process support engineers are deployed in more than a dozen countries. These engineers are usually located at or near customers' fab sites and service over 37,000 installed Applied systems, as well as non-Applied systems. AMAT tends to establish long term contracts with many of its foundry and fab clients.

Display Segment (7% sales): Equipment for the fabrication of flat panel displays. Applied is also extending its core LCD equipment technology into new mobility display segments that require smaller, high-performance LCD or organic LED (OLED) screens and touch capability. AMAT projects 2-digits long term growth rates for this segment, though I would expect flat sales for the next couple of years, given macroeconomic fears and contracting capex.

Energy and Environmental Solutions Segment (19% Sales): Manufacturing processes significantly similar to many of the semiconductors industry product lines, have allowed AMAT to apply it's expertise in the Solar Energy industry. Applied has developed a portfolio of solar PV wafer and cell fabrication technologies, making it the leading supplier of c-Si equipment worldwide in terms of revenue. In addition to innovative technology, these systems offer key manufacturing benefits to customers in high productivity, advanced ultra-thin wafer handling, and extensive automation.

- The solar energy industry currently finds itself in a cyclical downturn mainly caused by a global oversupply of solar cells, coming from government-subsidized chinese producers, dumping their production, and an overall excess capacity. The medium term looks bleak for the industry, with hardly any companies making profits. However, experts agree that the potential for significantly more efficient cells (compared to the relatively primitive current technologies) is huge. Applied will suffer along with this decline. However, long term prospects are fairly optimistic for the solar energy industry, and Applied will probably be a beneficiary of technological advances.

Sales by geographical region (70% of which comes from Asia, which concentrates most of the semiconductor foundries of the world):

- China 24%

- Taiwan 20%

- Korea 12%

- North America 19%

- Europe 11%

- Japan 9%

- Southeast Asia 5%.

Client concentration:

- Samsung 12%

- TSM 10%

- Intel 10%

Financial Highlights:

- Financial position is excellent: $2.16 bil in cash, $5.86 bil in current assets, $2.4 bil in current liabilities and $5 bil in total liabilities. Current ratio: 2.44. Leverage Ratio: 1.60.

- Net Margin - 10YAverage: +10.5%. Min: -6%. Max: +18.3%. Only 2 years of net losses.

- FreeCashFlows-to-Sales: 10YAverage: +14.8%. Min: +1.4%. Max: +21%. AMAT has performed exceptionally well in the last decade, with positive Free Cash Flows every single year, a pretty neat feat for a cyclical company.

- ROE 10YAverage: 12%. ROE 5YAverage: 12.8%.

- R&D-to-Sales 10YAverage: 14.5%. TTM research and development's expenditure stands at $1.2 billions, being by far the highest R&D budget in the industry.

What might go wrong? And other risks:

- Silicon systems segment is tied to the highly cyclical semiconductor industry. Applied will closely follow the industry's trend, expanding dramatically during upturns in which fabs invest heavily in capex, and contract heavily during downturns. While AMAT will fluctuate, it's peers will probably fluctuate more intensely, given AMAT's more diversified customer base.

- To maintain its market share, Applied must compete successfully in various segments with numerous competitors that only specialize in their submarkets. Therefore, Applied may not have the best-of-breed product in every segment in which it competes.

- AMAT is the biggest player in a highly fragmented industry, and it's not very likely that it will be able to increase it's market share significantly, except for acquisitions. Some argue that AMAT's expanding core responsibilities might trigger customer backlash over depending heavily on any single provider.

Thesis

I think the market is punishing's Applied Material for the following reasons:

- Too vulnerable and exposed to the PC market.

- My take: AMAT is indeed exposed to many fabs and semiconductor companies (Intel & TSM combined compose 20% of AMAT's sales). However, those companies, and most of the semiconductor industry is investing heavily in new generations of consumer's electronics, mainly tablets and smartphones. I guess(timate) that the semiconductor industry will continue growing in the future: The PC's will not disappear, they will not decline, they will not grow, sales (cyclically averaged) will stay flat. Mobiles and tablets will be the expansionary force that will keep the semiconductor growing.

- Solar energy sucks.

- My take: That's right completely right, but I daresay not in the long run. China derives 70% of its energy from coal burning, and its coal reserves will not last more than 30 years, given current consumption levels. This has pushed China's government to heavily subsidize alternative energy sources, especially solar energy, to the point in which the industry finds itself with excess capacity. Chinese producers are dumping their productions all over the globe, eroding profitability for almost all producers. The solar cell industry will probably be in pain for the next 2 to 3 years, until newer for efficient solar panels are developed and companies can compete in that newer technological environment. AMAT will probably benefit from technological changes that require new capex. Long term, AMAT's management projects 2-digits growth rate for the segment, and they are probably right, though for the short term they will be hurt, which management already recognize with a big write-down in it's Energy & Environmental Solutions division.

- The Silicon Segment competes in a highly fragmented market, with a high number of small, specialized competitors. Applied must maintain its technological innovation to keep up with the latest trends in chip manufacturing.

- AMAT has the highest R&D budget in the whole industry allowing it to reasonably compete in terms of innovation with many of its competitors. Also, its size and strong balance sheet will allow it to perform acquisitions, to an extent unimaginable for the competition. Both features should help AMAT stay in the forefront of technological advances. Even more so, most semiconductor manufacturing companies are of significant size, and Applied not only can perform exceptionally well as the only one-stop-shop in the industry: Applied's size (biggest single company among semiconductor equipment producers) makes it the ideal contractor for big companies such as Intel, Samsung, and TSM, given that AMAT is one of the few companies capable of responding effectively when big orders are requested.

Valuation

My base scenario assumes the following (forecast period 2013 - 2022):

- Silicon: Sales fall from $5.3 bil (2012) to $2.7 bil in 2014, and then grow at 8% for the forecast period. Operating margins: 30% (below historic 33%).

- Services: Sales fall from $2.4 bil (2012) to $1.9 bil (2014), and then pick up at 9% till the end. Op margins: 18% (vs 20% historic)

- Display: Sales fall from $750 mil to $600 (2014), and then grow at 11%. Op Margins of 20% (vs historic of 21%).

- Energy: Sales fell from $1.9 bil, to $0.8 bil in 2014, and then pick up a growth rate of 15%. Operating margins of 20% (vs historic of 23%).

- Capex stays at 4% of sales.

Estimated Free Cash Flows (millions):

2013: $1489

2014: $1224

2015. $1280

2016: $1490

2017: $1632

2018: $1790

2019: $1963

2020: $2155

2021: $2366

2022: $2600 + Terminal value of $27000

(To put it in context: The average yearly Free Cash Flow in the last decade has been slightly above $1.3 billions.)

Present Value of Base case (@10% discount rate):

$20.800 millions (x 8.5 2012FreeCashflows - x 10.8 2012 Earnings)

Per Share Fair Value: $16.75

I would argue that there is more upside than downside to the company for the reasons previously mentioned, which leave me with a range of potential valuations that start at $17 bil and an upside of $25 bil. (Per share range of values: $13.75 - $20.25)

The company presently trades at $13.2 billion dollars ($10.87 per share), leaving a margin of safety.

Disclosure: I am long AMAT.

Additional disclosure: I'm a novice investor trying to get feedback on my certainly cursory and primitive analysis of companies. I REALLY MEAN NOVICE.

Investment is most intelligent when it's most business like.

Stocks are not just things that wiggle up and down. Rather, they are fractional ownerships of businesses. This is doesn't seem to be the case with Apollo Group (APOL).

Apollo is one of the largest for profit education companies in the world, its core business being the University of Phoenix, which provides distance learning university degrees. The firm boasts an average ROE of above 40%, average revenue growth rate of close to 20%, low capex, free cash flow margins of 15%. Future prospects seem reasonable enough, given the ever increasing costs of higher education, and private universities ability to offer part-time study programs, friendly to those seeking to get an education while having a day job or looking for help when studying for professional certificates suchs as CPA or CFA. Even more so, the market cap of $ 3.3 billion seems attractive relative to levered FCF of $ 436 mil (or even better, average $700 mil in the last 5 years).

But there's a catch.

There are 2 classes of stock: Class A and class B.

Our Class A common stock has no voting rights. Our Executive Chairman and Vice Chairman of the Board control 100% of our voting stock and control substantially all actions requiring the vote or consent of our shareholders, which may have an adverse effect on the trading price of our Class A common stock and may discourage a takeover.

Class A is publicly trading and it has no voting rights. That is undesirable, but it doesn't make the company worthless.

Class B is the voting class, exclusively owned by the management of the firm, which are the only ones who have access to the board of directors. According to the 10-k the board can decide to dole out dividends to either or both classes of stock:

(...) holders of our Apollo Class A common stock and Apollo Class B common stock are entitled to receive cash dividends, if and to the extent declared by the Board of Directors, payable to the holders of either class or both classes of common stock in equal or unequal per share amounts, at the discretion of the Board of Directors.

I can only interpret this in the following way: The board of directors (management) can pay themselves (Class B) dividends, and not pay a single dime to Class A shareholders. So why would they pay anything to Class A shareholders? Out of generosity? Now, THIS does make the stock worthless, at least from a business investor's perspective.

As a value investor that likes to invest in businesses, I see no investment merit in this stock, since it's clearly NOT a fractional ownership of the business. It's a fractional ownership on the (naive) hope that management will distribute earnings when they have no incentive nor legal binding to do so. They can pay as much dividends as they want to themselves through the Class B, pay nothing to Class A, and we would have nothing to do but sit and watch Apollo's management get richer. Likewise, this company (at least though the Class A stock) has zero chances of being a takeover target, given that no institution will ever bother buying something over which it will have no control whatsoever.

I would really consider going long on Apollo if it had a different equity structure (where stockholders are actual fractional owners of the company). As I see it, this is either a bet on the company's management being stupidly generous (saying that companies' managements tend to be greedy would be an understatement) or a bet that some sucker will pay even more so than you did. Value investors will probably agree that neither option has any investment merit.

What about shorting it? Well, I wouldn't go that way either, since the company is a cashflow machine, and it has the earnings power to back a strong dividend to support the share price. I don't think they would do it anyway, since management has an insignificant ownership of Class A. But they could very easily do it, and that doesn't seem like a pleasant prospect either.

So I shall quote Charlie Munger: "When in doubt, don't" and keep myself busy with more interesting investment ideas.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

"I can state the supreme law of Mediocristan as follows: When your sample is large, no instance will significantly change the aggregate or the total. In Extremistan, inequalities are such that one single observation can disproportionately impact the aggregate, or the total." Nassim Nicholas Taleb

On "The Black Swan" N.N.Taleb elaborates extensively on the limits of forecasting in the fat-tailed land of extremistan, to which economic variables such as earnings and dividends belong. Part of the reason is based on the faulty cognitive gear we humans have been endowed with by evolution; part of it is due to the extremely lumpy nature of economic variables that, among other things, tend to exhibit high kurtosis. The higher the kurtosis, the more irrelevant measures of dispersion (StdDev & Var) become. The higher the kurtosis, the higher the uncertainty and the higher our error rate becomes when trying to forecast economic variables.

We've all seen how stock prices tend to exhibit high kurtosis (with freak events as the 23-sigma crash of 1987), falsifying thereby any theory that assumes Gaussian distributions such as CAPM and BlackScholesMerton.

To analyze and forecast price behavior is, to a great extent, the study of the market's expectations. But what about the underlying economic variables that prices try to estimate? Here I show you some really interesting numbers anyone can compute relating to the statistical behavior of the S&P 500's dividends and earnings change throughout time. I think that constantly reminding me of these figures makes a humbler, more rational investor.

----------------------------------

DIVIDENDS:

Mean= 3.92%

StdDev= 11.16%

Skewness= -0.09

Kurtosis= 6.03%

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EARNINGS:

Mean= 9.21%

StdDev= 53.05%

Skewness= 10.37

Kurtosis= 140.60 <====== O__O!

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[Source: www.econ.yale.edu/~shiller/data.htm]

[Statistical Computation performed with STATA]

In the last 140 years of financial history, the average earnings' year-to-year growth has been of 9.21%. Dividends grew, on average, about 3.92% a year. But how relevant are these figures when it comes to forecasting future earnings/dividends/cashflows? Orthodox financial theory would mislead you to look for the standard deviation of each respective time series. But to do that, you first need to assume that standard deviation is not completely irrelevant. How to figure that out? A simple rule of thumb is to look at kurtosis. If excess kurtosis is high enough, the more irrelevant variance becomes owing to the large impact that rare events can carry when they take place.

I find the earnings kurtosis to be an extremely interesting datum. Earnings exhibit a kurtosis of 140, which is insanely high, reflecting the disturbingly uncertain nature of corporate profits. More importantly, company management can [and almost always do] perform earnings smoothing. But as analysts what we actually care about are cashflows. Cashflows, too, can be "managed" in the way earnings are, but generally to a smaller degree. Cashflows effectively are more volatile, making me guess that cashflows' kurtosis is even higher than the earnings' 140 kurtosis.

When you buy a stock, you're buying a fractional ownership in the company's profits. Value investing involves figuring out how much a business is worth, and buying its stock for a lower price. But can you reliably value a company's future cashflows, when they exhibit a kurtosis of 140 or higher? Of course not! On an aggregate level, such as the S&P 500, or the macroecon, is pretty much unpredictable. You may get it fairly right 9 out of 10 times. But when you fail, you will usually fail severely bad, making your error rate monstrous.

Furthermore, when you try to value a single business (and not the S&P aggregate) statistics teaches us that estimating 1 single event (single company's results) will always carry a higher error margin than estimating an average (the performance of a collection of companies that even each other out because of imperfect correlation).

I don't think this means one should abandon the investing business altogether, but it definitely means that we should seriously consider what circle of competence means for us as business analysts. We all know that we should stick to our circle of competence. Warren Buffett (aka "The Lord") claims he doesn't understand 90% of the businesses out there trading in the markets. If Warren's circle of competence is about 10%, I guess my prospects as a mere mortal are definitely below that.

Takeaway: Don't undervalue your circle of competence and margin of safety, DO UNDERVALUE your skills. Because odds are that the overconfidence cognitive heuristic is always lurking in the back office of your mind. ^^

Peace!