Short-Term Problems, Long-Term Opportunity

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

While the PC market continues to grow at a slower and slower pace, the market for mobile devices, especially smart phones and tablets, is exploding. There are many winners which will profit handsomely from this trend, as growth in device sales will drive growth in the sales of components, such as processors. And as devices get smaller chip manufacturers continue to push the limits of silicon technology, creating chips which use less power and generate less heat. To fund all of this, companies need to to spend considerable amounts of money on new fabrication equipment. And one the the prime beneficiaries of this is Applied Materials (NASDAQ: AMAT)

Company Profile

Applied Materials is the world's largest supplier of semiconductor manufacturing equipment. Their equipment is used at every semiconductor fabrication plant in the world, allowing for high-volume manufacturing of complex devices. The company is split into four reporting segments.

  1. Silicon Systems - Develops and manufactures equipment used to fabricate semiconductor chips. The company is the number one equipment supplier to the global semiconductor industry. In 2011 the segment booked $5,415 million in sales, or 51.5% of total sales.
  2. Display - Develops and manufactures equipment to enable the manufacture of liquid crystal displays for Televisions, computers, tablets, and other consumer electronic devices. In 2011 the segment booked $699 million in sales, or 6.6% of total sales.
  3. Energy and Environmental Solutions - Develops and manufactures equipment and systems used to produce energy generating products, such as solar panels. In 2011 the segment booked $1,990 million in sales, or 18.9% of total sales.
  4. Global Services -  Includes products and services designed to improve the performance of the fabrication operations of manufacturers. Equipment support and maintenance and automation systems fall under this segment. In 2011 the segment booked $2,413 million in sales, or 23% of total sales.

The industry in which Applied operates is extremely cyclical. Since the fortunes of the company are tied to the capital expenditures of its customers, downturns in demand can greatly affect the company's financial performance. Furthermore, Applied's customer base is fairly concentrated. In 2011 three semiconductor manufacturers accounted for 52% of the Silicon Systems segment's net sales while three LCD manufacturers accounted for 54% of the Display segment's net sales. Both of these conditions can lead to an extremely volatile cash flow, making any predictions regarding future performance difficult. 

Intel (NASDAQ: INTC) is one of Applied's larger customers. Intel doubled its capex spending in 2011 from around $5 billion to $10 billion, and plans to spend in the neighborhood of $13 billion in 2013, $8 billion of which is expected to go towards fabrication equipment. This occurs as Intel is pushing the limits of semiconductor manufacturing to smaller and smaller transistor sizes. As Intel competes with ARM based chips used widely in mobile devices, the company will need to spend heavily to establish a technological advantage.

Another company, Taiwan Semiconductor (NYSE: TSM), also plans to increase capex spending in 2013. The company is the largest contract chip manufacturer and expects to spend heavily to increase capacity. All of this bodes well for Applied Materials going forward. 

The Stock

<img src="http://media.ycharts.com/charts/0b39071e7fe667826e2a5de4590f33d7.png" />

AMAT data by YCharts


Applied's stock price fell from around $20 per share before 2009 to less than $10 per share. Since that time the stock has largely stayed within a range, currently trading around $11 per share. 

Financial Overview

In order to estimate the fair value of Applied Materials we need to look at both the balance sheet and the cash flow statement. In November 2011 Applied purchased Varian semiconductor for a price of $4.2 billion. This acquisition reduced the cash balance on the books from over $6 billion to just under $2 billion. The most current balance sheet looks like this:  

<table> <tbody> <tr> <td><strong>Cash and cash-equivalents</strong></td> <td>$2,164</td> </tr> <tr> <td><strong>Investments</strong></td> <td>$1,058</td> </tr> <tr> <td><strong>Long-term debt</strong></td> <td>$1,946</td> </tr> <tr> <td><strong>Net cash</strong></td> <td>$1,276</td> </tr> <tr> <td><strong>Net cash/share</strong></td> <td>$0.98</td> </tr> </tbody> </table>

The company easily has enough cash and investments to cover the debt, leaving about $1 per share of net cash. Prior to the purchase of Varian the company had about $4 of net cash on the books. The balance sheet looks solid, and interest payments on the debt are only about $100 million per year.

Now we turn to the cash flow. Here is the company's revenue and cash flow for the past five years.

<table> <thead> <tr><th>(In Million $) </th><th>2007 </th><th>2008 </th><th>2009 </th><th>2010 </th><th>2011 </th></tr> </thead> <tbody> <tr><th>Revenue </th> <td>$9,734 </td> <td>$8,129 </td> <td>$5,013 </td> <td>$9,549 </td> <td>$10,517 </td> </tr> <tr><th>Operating Cash Flow </th> <td>$2,209 </td> <td>$1,710 </td> <td>$332 </td> <td>$1,723 </td> <td>$2,426 </td> </tr> <tr><th>Capital Expenditure </th> <td>$-265 </td> <td>$-288 </td> <td>$-249 </td> <td>$-169 </td> <td>$-209 </td> </tr> <tr><th>Free Cash Flow </th> <td>$1,944 </td> <td>$1,422 </td> <td>$84 </td> <td>$1,554 </td> <td>$2,217 </td> </tr> </tbody> </table>

As I've mentioned, revenue and cash flow can be extremely volatile. The financial crisis of 2008-2009 crushed Applied's revenue, nearly cutting it in half, and reduced profitability to almost nothing. Both have since recovered, but weakness in the PC market has caused Applied to recently announce a 9% cut in its workforce. The cost savings are expected to be between $140 - $190 million per year. This comes along with the expectation that sales for the last quarter of 2012 will fall considerably from the same period in 2011. 

Instead of looking at free cash flow I prefer to look at owner earnings, which is a similar but more useful measure. I calculate owner earnings by adding the net income, depreciation and amortization, and certain non-cash charges. I specifically exclude changes in working capital. To this I add the tax-adjusted interest payments, since interest expense is tax deductible, and subtract the 5-year average capital expenditure.  

<table> <thead> <tr><th>(In Million $) </th><th>2007 </th><th>2008 </th><th>2009 </th><th>2010 </th><th>2011 </th></tr> </thead> <tbody> <tr><th>Net income </th> <td>$1,710 </td> <td>$960 </td> <td>$-306 </td> <td>$938 </td> <td>$1,926 </td> </tr> <tr><th>Depreciation & amortization </th> <td>$268 </td> <td>$320 </td> <td>$291 </td> <td>$305 </td> <td>$246 </td> </tr> <tr><th>Investment/asset impairment charges </th> <td>$0 </td> <td>$39 </td> <td>$240 </td> <td>$259 </td> <td>$-30 </td> </tr> <tr><th>Stock based compensation </th> <td>$0 </td> <td>$178 </td> <td>$147 </td> <td>$126 </td> <td>$146 </td> </tr> <tr><th>Other non-cash items </th> <td>$198 </td> <td>$37 </td> <td>$131 </td> <td>$37 </td> <td>$-8 </td> </tr> <tr><th>Interest Payments </th> <td>$38 </td> <td>$20 </td> <td>$21 </td> <td>$21 </td> <td>$59 </td> </tr> <tr><th>Avg Capital Expenditure </th> <td>$-236 </td> <td>$-236 </td> <td>$-236 </td> <td>$-236 </td> <td>$-236 </td> </tr> <tr><th>Owner Earnings </th> <td>$1,968 </td> <td>$1,314 </td> <td>$282 </td> <td>$1,443 </td> <td>$2,091 </td> </tr> </tbody> </table>

The owner earnings in this case turn out to pretty similar to the free cash flow. Because of the volatility of Applied's cash flow I'll take the 5-year average owner earnings and use that as the starting point for my valuation. I'll exclude the results from 2009 due to the extraordinary nature of the financial crisis. This average value is $1,704 million.

Valuation

I use a discounted cash flow analysis to estimate the fair value of a Applied Materials. I will use a discount rate of both 12% and 15% and use these values to define a fair value range. My base value for owner earnings will be the $1,704 million calculated from above, and I'll assume growth of just 3% per year. Using these parameters I arrive at a fair value range of $11.83 - $15.52.

The Bottom Line


Applied Materials stands to benefit from the increase in capex spending coming from companies like Intel and Taiwan Semiconductor. Even though cash flows are volatile, the company has been consistently profitable and able to cut costs when necessary. The current market price of the stock is below my fairly conservative fair value range, and at the current price Applied Materials offers a great value.

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