Applied Materials: Looking for the Bottom

Feb 28 2001

In Latin, "amat" means "he loves." But to hear Wall Street analysts speak of Applied Materials , love is the furthest thing from their minds when evaluating the semiconductor equipment company. Their short-term negative sentiments are grounded entirely in the numbers and projections coming out of the semiconductor and chip manufacturing sector for this year.

Delving into Applied Materials' business is headache-inducing for most laymen - even for those with a working knowledge of the sector. Basically, Applied makes equipment to produce chips. During market downturns, many analysts look to Applied as an indicator for overall weakness in the industry. If manufacturers see less demand, then their demand for capital equipment and services - provided by Applied and its competitors - will lag, too.

Industry organization Semiconductor Equipment and Materials International released a report last Wednesday noting that January orders for chip equipment from North American makers fell to $1.9 billion, a 21 percent drop from December 2000. The decline is said to be the sharpest in 10 years. And as companies like Intel , Motorola and Texas Instruments warn of slipping demand and cost-cutting, the near-term outlook for equipment is less than rosy.

This is ironic because the industry is in the midst of technological advancement. The effectiveness of a semiconductor is largely correlated to wafer size - the unit of conductive material, be it silicon, germanium or another element. When the slowdown started, Applied and rivals Novellus Systems and Lam Research were pushing equipment to make larger wafers. The move from 200mm, or 8-inch wafers, to 300mm, or 12-inch wafers, offers long-term growth potential for chipmakers. A 300mm wafer has more surface area and allows for higher productivity and volume per wafer - desirable in a world of complex devices that can tax the capacity of 200mm wafers. But with capital expenditures down across the semiconductor industry, the rush for innovation and increased capacity has slowed.

Wall Street analysts have precisely this outlook for Applied Materials. According to Zacks, of the 29 analysts covering the stock, 13 have an "intermediate" rating, seven have a "neutral" position and one rates the company a "sell." "Based on its trough valuation [lowest historical price-to-earnings ratio], I feel this stock has 10 to 30 percent more to decline," says Wells Fargo Van Kasper analyst Susan Crossley, who rates the stock a "sell." In 1996, the latest major decline in semiconductor capital spending, Applied Materials' trailing P/E ratio ranged from 7 to 14. Based on her estimates for an overall industry contraction of 15 percent in 2001, Crossley believes Applied stock should settle at $29. She thinks that the downturn has at least three quarters to go. The stock has been trading in the $40 to $50 range since November 2000.

Lowered revenue estimates and Applied's inability to forecast revenue expressed in its Feb. 13 earnings announcement merely confirmed that the stock price's rapid fall from September to January was warranted. Tim Arcuri, analyst at Deutsche Bank Alex. Brown, hopes that Applied doesn't become a victim of its own success in down times.

"When you are as big as they are, it's hard to outgrow the industry. But they did take early initiatives to cut costs," he says, praising Applied's management team led by CEO James Morgan. Arcuri rates Applied a "market perform" and mentions that the company was caught somewhat off-guard by the move to 300mm wafers. "Novellus was more focused on the transition and completely redesigned their product," he says. But Arcuri doesn't feel that Applied will lose any market share at this point.

In his most recent note, John Pitzer of Credit Suisse First Boston picks at the problem that is dogging almost every major player in tech: inventory. Pitzer, who has a "buy" rating and a price target of $55 for Applied, cautions that equipment shipped at the end of 2000 has yet to be used by many of Applied's customers and, looking back, says the shortage that created the backlog was far overstated. In the numbers, although Applied had $190 million of backlog due to order cancellations or currency-valuation adjustments for its fiscal first quarter, the loss is slim considering it has $2.73 billion in revenue. Still, Pitzer warns that the number of order delays could increase in the current quarter - after matching July 1998's record cancellations last quarter.

According to Zacks, analyst consensus estimates call for $1.85 earnings per share for the fiscal year ending in October, a 22.5 percent year-over-year decline. This is roughly 70 cents per share less than the consensus estimate made prior to Applied's first-quarter earnings call. While industry analysts may have had their fill of downgrading Applied Materials during the past few weeks, expect the company's stock to be affected by cautionary announcements from any player in the semiconductor space. Many analysts, however, say that while Applied is a leading indicator of a downturn, its stock will follow its customers upward in a market rebound. So as Applied begins to settle on a valuation, watch for a rebound in chips and semiconductors to lead Applied upward.