Applied Materials : (AMAT)

INVESTMENT THESIS This week's Focus Stock of the Week is Applied Materials Inc. (AMAT: $12), which carries Standard&Poor's highest investment recommendation of 5-STARS, or Strong Buy. We think AMAT's business will soon be running on all cylinders, driven by its Silicon segment, which should benefit from higher memory orders and the transition to more advanced technology. We see the flat panel display business rising on better customer utilization and profitability. In addition, we project greater solar-related orders, as China-based manufacturers expand capacity, and see this segment becoming profitable in FY 10 (Oct.). Earlier this year, we believe semiconductor manufacturers across the supply chain acted swiftly to reduce inventory levels and chipmakers quickly cut production levels, amid an uncertain economic landscape. These actions have led to a much better supply and demand balance, in our view, and we now see customers focusing their spending on more advanced technology, as demand begins to slowly creep back. We believe the transition from DDR2 (double data rate) technology to DDR3, represents a large potential revenue opportunity for AMAT in calendar year 2010. Following several quarters of under-investing, we project front-end semiconductor equipment spending to sharply rebound more than 40% in calendar year 2010. This follows our outlook for a 40%-50% decline in 2009 and a more than 30% drop in 2008. Going forward, we project solar-related sales to benefit from rising end-demand and an increase in capital spending plans from customers. We think credit conditions are easing and see increased orders as China-based manufacturers appear to be expanding capacity in anticipation of higher demand within its local region. Additionally, we think AMAT's solar-served addressable market will grow more than 70% by 2013 and see opportunities in areas such as the LED market. The shares are currently trading at a discount relative to comparable front-end semiconductor equipment manufacturers, based on our price-to-sales analysis. We expect AMAT to focus on turning solar into a profitable business within the next 12 months rather than solely focusing on revenue growth, which we believe should improve investor sentiment. We also believe that the company will announce another restructuring move in the near term, which could potentially result in greater margin expansion than we currently project. INDUSTRY PROFILE We look for the semiconductor equipment industry to rebound in 2010, following several quarters of under-investing by semiconductor manufacturers. We expect most demand for semiconductor equipment to be focused on advanced technology purchases heading into 2010. Independent research company Gartner forecasts worldwide semiconductor capital equipment spending to decline 48% from 2008 levels. However, for 2010, the research firm projects a rebound of 39%. Gartner sees memory companies that make DRAM (dynamic random access memory) and NAND flash memory (a type of nonvolatile memory capable of fast data writing) beginning to spend on copper implementation and double patterning at lower technology nodes. Gartner estimates that capacity-related equipment purchases will ramp up by the second half of 2010, as businesses and consumers spend more heavily on electronic goods and semiconductor growth is more consistent. We believe tracking orders and utilization rates are the single most important factors to gauge the health of the semiconductor equipment industry. In September 2009 (preliminary results), equipment companies reported $732.8 million in worldwide orders for North American-made chip equipment (based on a three-month average) and a book-to-bill ratio of 1.17, according to Semiconductor Equipment and Materials International (SEMI), a global industry trade association. We think bookings for the most recent cycle appear to have hit a trough in March 2009, reaching a monthly low of $245.6 million. Since then, monthly bookings have almost tripled. Monthly bookings in the most recent downturn fell 85% from the May 2007 peak, when they reached $1,641.9 million. Customer utilization levels appear to be rising sharply, as companies across the supply chain restock depleted inventory levels and anticipate higher demand. We believe that the first quarter of 2009 marked the lowest utilization rate ever recorded by the semiconductor industry, at 55.6%. We project that the overall utilization rate will continue its upward trend in the fourth quarter, nearing the 90% level that typically signals a need to add capacity. In 2010, we expect utilization levels to follow seasonal patterns and be at more normalized levels. BUSINESS PROFILE Applied Materials is a market share leader in the manufacturing of semiconductor, display and solar capital equipment. Santa Clara, CA-based AMAT divides its business into four segments: Silicon Systems Group, Applied Global Services, Display, and Energy and Environmental Solutions. The Silicon segment, which we project will represent 39% of FY 09 (Oct.) total sales versus 49% in FY 08 and 67% in FY 07, is focused on developing and selling equipment for use in the front end of the semiconductor manufacturing process. The Silicon segment includes semiconductor capital equipment for etch, rapid thermal processing, deposition, chemical mechanical planarization, and metrology and inspection. AMAT's equipment in the silicon segment addresses most of the primary steps in chip fabrication. The Applied Global Services segment, which we expect to comprise 29% of FY 09 sales compared to 29% in FY 08 and 22% in FY 07, provides solutions to optimize and increase productivity at customer facilities. The segment includes products and services to improve the efficiency and reduce operating costs at semiconductor, display and solar customer factories. Applied Global Services products consist of spares, services, certain earlier-generation products, and remanufactured equipment. We anticipate that the Display segment will account for 8% of FY 09 sales versus 12% in FY 08 and 9% in FY 07. The segment develops equipment for manufacturing Liquid Crystal Displays (LCDs) for TVs, personal computers and other video-enabled devices. The flat panel display equipment industry has historically been highly cyclical due to abrupt changes in customers' manufacturing capacity requirements and spending, which reflect capacity utilization, demand for customers' products, and inventory levels relative to demand. The Energy and Environmental Solutions segment, which we project will comprise 24% of FY 09 sales versus 10% in FY 08 and 2% in FY 07, offers manufacturing solutions for both wafer-based crystalline silicon and glass-based thin film applications. AMAT's SunFab Thin Film Line is a turnkey system that manufactures thin film silicon solar modules four times larger than average panels offered by competitors, intended for large-scale applications such as solar farms. AMAT's presence in the solar equipment industry has come about mainly through three major acquisitions since 2006. COMPANY OUTLOOK AND GROWTH OPPORTUNITIES The following are the primary growth opportunities we see within each AMAT segment in the foreseeable future: We believe the biggest growth catalyst for the Silicon segment in the near term is the transition from DDR2 (double data rate) technology to DDR3, which we think most DRAM memory manufacturers will need to spend heavily on in 2010. Both, DDR2 and DDR3, are types of DRAM chips that are found in personal computers. DDR3 technology is the successor to DDR2 and offers advantages such as greater speed and a reduction in power consumption. Applied Materials expects the crossover to create a served market opportunity of about $2 billion.

In AMAT's Display segment, we believe that utilization rates for a number of leading-edge customers have reached above 90% after levels troughed below 50% earlier this year, and profitability for many of these manufacturers appears to be improving, which should lead to higher spending for equipment, in our view. The company sees the next phase of its Gen 8.5 build-out also beginning. AMAT's Gen 8.5 systems can process substrates sized at 2.2 x 2.5 meters, which enables the production of up to six 55-inch LCD TV screens. We expect to eventually see the transition toward the larger Gen 10 systems, capable of mass-producing panels between 57 and 65 inches. We see strong long-term growth prospects for the Energy and Environmental Solutions segment as well. We expect solar PV installations to grow at a compound annual rate of over 30% through 2012, with China and the United States being the biggest growth drivers. In 2010, we project about 4 gigawatts of capacity will be added, as China-based manufacturers appear to continue to expand capacity despite excess industry supply and are benefiting from a relatively favorable Chinese lending environment. We believe the company is also likely to benefit from a flattening of, or at least a slower decline in, polysilicon prices, as well as falling module prices. AMAT believes that its solar-served addressable market can grow to a $6.5 billion opportunity in 2013 from $3.7 billion in 2008. This is based on the assumption that global solar installations rise to 29 gigawatts in 2013. Currently, AMAT's thin film equipment can produce solar panels with 9.25% efficiency at $1.20 per watt. We believe that the company will be able to increase its panel efficiency to 10% by the end of next year at a cost of under $1 per watt. In our view, AMAT's goal of 12% panel conversion efficiency at $0.70 cost per watt by 2012 is attainable, which should make it a more attractive product and result in higher revenue. We also think recent R&D efforts in areas such as LEDs represent a potential opportunity for AMAT and could allow new products to show up in the backlog during calendar year 2010. EARNINGS We project an operating loss of $0.15 per share for FY 09, which excludes $0.16 in non-recurring charges, but see EPS of $0.33 in FY 10 and $0.95 in FY 11. We project the gross margin to widen to 37% in FY 10 versus our projection for a 27% margin in FY 09, driven by a higher revenue base and tight cost control. AMAT has been able to reduce its quarterly revenue breakeven level to $1.2 billion, by our analysis, and we see the potential for additional restructuring moves to further reduce its cost base. VALUATION AMAT was recently trading at about 2.46X our calendar year 2010 sales per share forecast of $4.94, a discount to large front-end semiconductor equipment peers, which traded at a P/S multiple of about 2.62X our 2010 estimates. We derive our 12-month target price of $17 by applying a price-to-sales (P/S) multiple of 3.4X to our calendar year 2010 sales per share estimate, as we think a premium multiple for AMAT is warranted given its strong financial position and leading market share. In our view, the discount the company's shares are currently receiving compared to peers is due to uncertainty facing the solar industry as well as its solar business. However, we expect investor sentiment to begin to improve and multiples to rise once AMAT begins to deliver profitability in its solar-related business, which we see occurring over the next six to 12 months. Our valuation is supported by AMAT's five-year historical P/S multiple, which is about 3.2X. CORPORATE GOVERNANCE Overall, we are satisfied with AMAT's corporate governance practices. On the positive side, the company has independent directors on the audit, nominating and compensation committees and independent directors make up a supermajority of directors. In addition, the full board of directors is elected annually, no former CEO of the company serves on the board, a simple majority vote of shareholders is required to approve a merger, and there is not a dual class capital structure in place. However, AMAT has a number of corporate governance issues that we view unfavorably. Issues related to the board of directors include: shareholders do not have cumulative voting rights in director elections; the positions of chairman and CEO are combined; and the board is authorized to increase or decrease the size of the board without shareholder approval. Other concerns we have include that the board may amend the bylaws without shareholder approval and there is no disclosure of mandatory holding periods for restricted stock after vesting. INVESTMENT RISKS Risks to our recommendation and target price include a weaker-than-expected recovery in any of AMAT's end markets, namely semiconductor equipment; lower-than-projected demand for chips; an extended period of time before its solar business reaches sustained profitability; and unexpected market share loss in any of AMAT's core businesses. CONCLUSION We believe AMAT offers significant capital appreciation potential given our view of its compelling valuation, its leading market share position in all its end-markets, superior financial position relative to peers and high revenue growth potential over the next 12 months. We also note that its dividend yield, recently about 2.0%, is a rarity among semiconductor equipment peers./Angelo Zino

02-Nov-2009 10:00:21 (14754691)   Copyright 2009 The McGraw-Hill Companies, Inc, Standard & Poor's, a division of The McGraw-Hill Companies, Inc., and their affiliates (collectively, "S&P"). Reproduction of this content in any form is prohibited except with the prior written permission of S&P.