3 Beaten-Down Tech Stocks Set for a Rebound

| About: Applied Materials, (AMAT)
This article is now exclusive for PRO subscribers.
By David Sterman

Bearish comments from analysts at JP Morgan and Robert W. Baird last week regarding tech spending have put an already-weak sector under even greater pressure. Major tech names like Intel (Nasdaq: INTC) and Dell (Nasdaq: DELL) are retreating from recent gains and some tech stocks are quickly falling into the abyss.

On Tuesday, shares of Applied Materials (Nasdaq: AMAT), Seagate Technology (NYSE: STX), and Symantec (Nasdaq: SYMC) all hit 52-week lows. For existing shareholders, it's fair to wonder if it's time to cut their losses. And for investors that have avoided this sector as it has tumbled, do these newly-cheapened stocks signal it's time to jump in? Let's take a look...

Applied Materials
One of the key challenges for all tech stocks involves the steep peaks and dips in revenue and profit streams. With such robust swings, investors always apply relatively low multiples. In the area of semiconductors, investors are often even more wary, as capital spending cycles enter into boom and bust cycles with alarming frequency. Applied Materials, for example, saw sales plunge -38% in fiscal (October) 2009, yet is in the midst of a fresh growth spurt this year that should boost sales +70% to +80%.

But fear springs eternal for this sector, and investors are already bracing for the next plunge. Perhaps that fear is quite premature. After all, capital spending for advanced semiconductor equipment -- for which Applied Materials is the acknowledged global leader -- is often a function of the cash customers have at their disposal. Right now, Applied Materials' customers are fattening their balance sheets again after a string of solid results from chip makers.

Looking ahead, analysts still think Applied Materials will see sales grow in fiscal (October) 2011, perhaps in the +10% to 20% range. That may prove to be optimistic or pessimistic, but one thing is for sure: the company generates loads of cash in good times or bad. Sure, it lost $235 million in free cash flow in 2009, but it generated $6.7 billion in positive free cash flow during the previous five years. It would take an absolute plunge in global chip equipment spending for Applied Materials to move back into the red in terms of free cash flow.

In a bid to please investors, Applied Materials recently shut down its money-losing SunFab unit that makes thin-film solar panels. That move is expected to boost profits and once again tighten the company's core focus on the semiconductor business (although it will retain some exposure to the solar industry). That move should allow gross margins to rise back up next year into the mid 40% range from a current 39%, according to Needham & Co. Operating margins should also rebound back into the low 20% range. Yet shares have moved even lower since that July 21st announcement and are now at levels last seen in 2003 (excepting the early 2009 swoon which cratered many stocks).

Assuming sales rise at a moderate pace in 2011, as analysts currently expect, then free cash flow could approach $1.5 billion -- roughly in line with what Applied Materials generated in 2006 and 2007. Back then, shares traded in a range of $15 to $25 -- well above the current price near $11.15.

As is the case with many tech stocks these days, Applied Materials can only rely on one catalyst to support shares: stock buybacks. The company's share count has already shrunk from 1.7 billion shares in 2004 to a recent 1.34 billion. The company could continue buying back 100 million shares annually without cutting into R&D spending or its $3 billion in cash and investments.

Applied Materials is expected to report third quarter results next Wednesday, August 18th. Management noted in July that the quarter was faring well, and if recent quarterly conference calls are any guide, management should again speak of a still-rising backlog of orders. Perhaps that will be what it takes to get shares out of the summer doldrums.

Seagate Technology
This hard-disk drive maker is also a victim of lousy sentiment toward the entire industry. Those bearish comments noted earlier from JP Morgan and Robert W. Baird specifically cited concerns about a slowdown in spending on PCs and servers. Seagate, which has exposure to both volume and pricing (both metrics are good when demand is strong, and bad when they're not) surely can post erratic numbers. When business was lousy in fiscal (June) 2009, the company barely broke even in terms of free cash flow. Yet in the fiscal year just ended, free cash flow surged to more than $1 billion. But the recent quarterly results also highlighted an emerging slowdown in demand, thanks in large part to cautious spending trends in Europe.

Yet even as sales weaken a bit, Seagate remains highly profitable. Analysts had been expecting EPS in the $3.60 range for both fiscal 2011 and 2012, but thanks to the incipient slowdown, have lowered those forecasts by a little more than a dollar to about $2.40. Seagate's shares trade for less than five times those lowered 2011 and 2012 profit projections.

To be sure, few positive catalysts exist in the near-term, so this stock is of much greater appeal to deep value investors than growth investors. Yet if the economy does begin to turn around, Seagate is a very high beta stock and could quickly double from current levels. Right now, few are envisioning such a scenario, as evidenced by Tuesday's new yearly low.

This security software maker has been in the doghouse ever since it acquired computer storage firm Veritas in 2005 for more than $13 billion. Investors didn't see the synergies of the deal back then, and they still don't. Adding insult, results at both of these disparate divisions began to lag their respective rivals, perhaps due to management's lost focus.

Even as organic growth has been lacking, Symantec has been a free cash flow machine, routinely spitting out about $1.4 billion in free cash flow, year after year. To boost growth, the company has put that prodigious cash flow back into play, recently acquiring a security software division from Verisign (Nasdaq: VRSN) for $1.3 billion. At least this deal has real synergies.

Symantec's ever-sinking stock is the result of tepid guidance issued in late July making clear that key customers were taking a longer time to commit to big new contracts. Like Seagate, Symantec has become a company with dim top-line prospects, but still-robust bottom-line prospects. And in this market, that trade-off holds little appeal.

Interested investors may want to check out Applied Materials' conference call next Wednesday to get the latest outlook on this seemingly moribund sector.

Applied Materials is the healthiest among these three stocks, though with shares trading for a little over 15 times projected profits, it lacks the absolute rock-bottom valuations seen with Seagate (4.5) and Symantec (9.6). All three of these companies are either first or second in the industries they operate and should rise anew when investors rotate back into the tech sector.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.