Why Don't These Stocks Reflect the Risk?

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The semiconductor industry can be cyclical and volatile, and as a result, can scare away a lot of investors. However, there are some companies in the sector that are still worthy of consideration. Applied Materials (NASDAQ: AMAT) is one of my favorite companies in the space as it is the leading manufacturer of equipment used to make semiconductors. In other words, it is the company that many semiconductor makers get their equipment from. I don’t question Applied Materials as a business, but my concern is whether the company is a good value, with shares up by more than 40% since late last year. Let’s take a closer look at Applied Materials, and then at a few alternatives elsewhere in the sector.

About Applied Materials

As mentioned, Applied Materials is one of the world’s largest manufacturers of semiconductor fabrication equipment, operating in four business segments. The largest is the Silicon Systems Group, which makes up 63% of the company’s total sales and develops equipment for virtually all of the front-end steps of chip fabrication. The Applied Global Services segment (26%) produces products and provides services intended on improving efficiency and productivity of customers’ facilities. The Display segment (5%) develops various equipment used in the manufacturing of LCD, LED, and OLED flat-panel displays. Finally, the Energy and Environmental Solutions segment (5%) makes products intended for the solar industry.

A major catalyst to the company’s future growth could come from the rising need for the most technologically advanced chip making equipment in the market. The computing market is slowly transitioning away from desktops and laptops and towards smartphones and tablets, which are getting more complex at a breathtaking pace. 

The volatility and unpredictability of the industry can be seen when looking at the company’s revenues over the past decade. The semiconductor business is a rare exception to the rule that revenues rise in good economies and fall in bad ones. It seems to be generally accepted that the economy is recovering and will continue to improve for the next several years. However, analysts’ estimates predict falling revenues this year, after a pretty sizable fall last year. Revenues are expected to rise in 2014 and 2015, but this is far from certain at this point.

*Note: Includes consensus projections for 2013-2015

Looks expensive...is it?

At 24.9 times this year’s expected earnings of 63 cents per share, Applied Materials does look to be a bit expensive. When I take a risk on a volatile and cyclical industry like this, I expect the valuation to reflect it. Earnings are expected to jump sharply to $1.14 and $1.29 over the next two years, but there is too much uncertainty in this for comfort. For instance, 2015 estimates from the 20 analysts who follow the company range from a low of $0.88 to a high of $1.80, a huge range.

Alternative plays: ASML and KLA-Tencor

ASML Holding (NASDAQ: ASML) designs, manufactures, and sells a variety of semiconductor processing equipment. The company specializes in photolithography systems, an area of equipment manufacturing in which it has a dominant 85% market share. As far as valuation goes, ASML is in the same boat as Applied Materials, trading at an even higher 30.4 times this year’s expected earnings. While the consensus calls for earnings to jump by 55% next year to $4.68 per share, the estimates range from $3.55 to $5.98, just as uncertain as Applied Materials. Maybe it’s just me, but paying such a high multiple for this kind of uncertainty seems like a poor risk/reward ratio.

KLA-Tencor Corp (NASDAQ: KLAC), just like ASML, is a leader in another specialized area of the semiconductor industry. The company is the world’s number one manufacturer of yield management and process monitoring systems for the industry. Profits of semiconductor manufacturers are highly dependent on the ability to maximize the yield (number of chips) per wafer, and KLA-Tencor’s systems are intended to help companies reach this objective. 

Of the three companies mentioned here, KLA-Tencor is the only one that trades at what I consider to be a reasonable valuation of 15 times this year’s earnings. Just like the others, earnings are expected to jump next year, but with a great deal of uncertainty. The difference is that with KLA-Tencor, you get compensated for taking the risk.

Conclusion

Considering that there seem to be some less expensive options out there, in order for me to become a buyer of Applied Materials I would need either a much better entry point, or a significant improvement in the company’s fundamentals. Pay attention to the company’s earnings report on Thursday, August 15 to see if the company’s outlook can shed any light on the uncertainty. On the other hand, if the report is less-than-stellar, it could create a more attractive entry point for the long term.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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