Applied Materials (AMAT) recently made an interesting bolt-on deal with the purchase of Kokusai Electric in a $2.2-billion cash deal. The deal seems to make sense, as the company is buying some growth, exposure to parts of the market which show modest growth, all at a reasonable multiple.
Deal Terms & Rationale
Applied Materials has reached a deal with KKR (NYSE:KKR) to acquire Kokusai in a $2.2-billion cash deal in order to gain expertise in high-productivity batch processing systems and services for memory, foundry and logic. Kokusai is set to become part of the Semiconductor Products Group of Applied Materials in a deal expected to close within a year of announcement date.
CEO Gary Dickerson praises the innovation of Kokusai and the rapid growth, thanks to exposure to the wafer fab equipment market. Customers include Samsung (OTC:SSNLF), TSMC (NYSE:TSM) and Intel (NASDAQ:INTC) as well as other big customer names as more than 3,000 patents allow for a strong IP position. The company has doubled sales between 2016 and 2018 to $1.49 billion, translating into a relatively modest sales multiple at around 1.5 times.
Applied notes that the deal comes in at 7.3 times EBITDA seen in 2019, which includes a non-quantified synergy number. This suggests about $300 million in EBITDA is anticipated from the deal, including synergies.
Applied Materials posted sales of $17.25 billion last year in which it reported a clean GAAP operating profit of $4.80 billion. While sales were up 19% for the year, fourth-quarter revenue growth of 1% was very modest with fourth-quarter sales coming in at a run rate of $16 billion. The company reported net earnings of $3.43 billion, equivalent to $3.17 per share, with adjusted earnings coming in eight cents higher.
The company ended Q2 with $5.2 billion in cash, equivalents and short-term investments, for a net debt load of a mere $0.1 billion, which will increase to roughly $2.3 billion upon the closure of the Kokusai deal. Obviously, with $4.8 billion in operating earnings power, that net debt load remains very modest and certainly manageable.
Last year's earnings power is not really representative as the semiconductor sector has cooled off in recent quarters. Based on the Q2 results for 2019, annualised revenues now run at just $14 billion with net earnings seen at around $2.7 billion, for earnings of roughly $2.75-3.00 per share.
Note that Applied has 948 million shares outstanding which make for a $42 billion equity and enterprise valuation at $44 per share. Based on the 2018 results, Applied Materials trades at 2.5 times sales, 8.8 times operating earnings and 8 times EBITDA. With the deal coming in at 7.3 times annualised EBITDA (including synergies) while promising growth, the transaction seems to make sense.
This sounds like a fair multiple, especially as the company has a sound balance sheet, although the anticipated synergies are not included. Assuming the $300 million in reported EBITDA and estimating $30 million in D&A, I peg additional EBIT at $270 million. Assuming 4% cost of financing, that leaves a pre-tax earnings contribution of $180 million, or perhaps $150 million after taxes, equivalent to about $0.15 per share.
Given the fact that third-quarter sales are seen flattish compared to Q2, it suggests that we might see stabilisation and growth from now onward again, as the bolt-on deal suggests that earnings power comes in around $3 per share, all while leverage is very modest, translating into a 14 times earnings multiple.
Some Valuation Thoughts
Like the rest of the sector, shares of Applied have seen a huge momentum run in recent years with shares quadrupling from $15 to $60 in the two-year period between the spring of 2016 and 2018. Shares collapsed to $30 again late last year, now having rebounded to $44 again.
Given the current earnings multiples and still fair valuation, multiples remain reasonable and while current momentum is a bit soft compared to some very strong quarters before, reality is that current margins and the revenue base are still quite strong on historical standards, yet the same applies to multiple other players in the industry.
While I have long admired Applied for a very modest valuation amidst a sound balance sheet, one has to recognise at the same time that Applied does not offer the best growth within the industry, as I believe the current valuation is largely fair. That said, I am usually fond of bolt-on deals as they can be integrated fairly simply and allow for realisation of real synergies. This latest bolt-on deal sounds fair as well, yet I fail to see an immediate trigger from here other than a general recovery in the semiconductor space earnings and valuation momentum. This makes that I am not chasing the shares at this point in time.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.