Citigroup Investment Research
The Incredible Changing Bear Case - Semi Cap Beat Vol. 72
November 13, 2005 SUMMARY
* Following another week of investor mtgs, we sense many continue to doubt our recent checks that TSMC is ordering in current Q - before YE2005. More subsequent checks confirm these tools will start shipping next Feb w/TSMC ordering ~10-15k wsm of capacity (~$800MM-$1.2B) from now thru CQ2:06.
* Bear case shifting yet again - first from memory spend implosion, to shallow upturn, and now to what bears contend will be a short upturn. While this may prove true, big NAND orders (Samsung/Toshiba), steady INTC, unexpected STM, and now TSMC mean all spending cylinders liable to fire next 2Qs.
* Despite heavily discounting the order ramp in C2003, we note equipment stocks still rose ~40% after orders began growing.
* See C2006 EQUIPMENT spending +15-20% y/y, as capex reverses facilities-skewed trend of C2005. Too early to sell equipment stocks as utilization not liable to peak until CQ3:06 - favor AMAT large-cap, AEIS small-cap.
VALUATION AND RISKS
Applied Materials Inc. (AMAT--$17.96; 1H)
Valuation
We rate AMAT Buy/High Risk (1H) with a target price of $22.
With sharply reduced manufacturing cycle times at equipments OEMs allowing
swift corrective action by chipmakers in response to excess inventories, our
analysis suggests that the semiconductor equipment industry downturn will be
shorter and shallower than any in recent memory. As our analysis suggests that
most front-end equipment companies are thus unlikely to lose money at any point
in the downturn, we believe that investors should focus on a metric that
accurately captures cross-cycle earnings power. We thus focus on "normalized"
earnings on the notion that the downturn will be more muted than any such
downturn in recent memory. If we average peak rolling four quarter EPS of
$1.18 (FQ4:06) and trough (fully taxed) rolling four-quarter EPS of $0.64
(FQ4:05), we arrive at a normalized full year EPS estimate of $0.91.
We then note that the average 10-year historical S&P500 multiple (excluding the
1998-2000 Asian crisis/market bubble time period) is approximately 18.4x
earnings. As semiconductor equipment capital spending is likely to continue
growing in the high single digits % CAGR (or roughly 2x global GDP), we assign
a 10% premium to the market for bellwether AMAT, and arrive at a multiple of
20.2x earnings.
Applying this 20.2x multiple to nearly $1.00 in normalized earnings power, we
arrive at a fair value of approximately $20. As this is based on cross-cycle
normalized earnings, we consider this to be "fair value" for the stock.
On a book value basis, the ten-year historical average is 4.7x. Applying the
historical multiple to an estimated book value per share at the end of CY2005
of $5.33 yields a price target of roughly $26 after rounding up.
As our analysis of industry fundamentals lead us to believe that the downturn
will be short and shallow, we believe the most appropriate valuation metric is
one that takes into account this more muted cyclical downturn. However, as
many investors are still concerned about the more traditional price to book
method of valuing stocks, we do not wish to completely discount this. We thus
assign a weighting of 75% to our normalized earnings method and 25% to book
value. Therefore we arrive at a price target of $22.
Because this methodology and result should be somewhat consistent regardless of
the point in the cycle, we would view this as a barometer of "fair value"
whereby, all things being equal, meaningful deviations above or below should
serve as stock triggers.
Risks
We rate AMAT High Risk, primarily due to stock price volatility as well as
earnings volatility. The following are key risk factors:
* Our valuation methodology is based on the assumption that semiconductor
capital equipment cycle will exhibit a shallower downturn than previous
cycles. As fab utilization and capital equipment orders are closely
linked to stock price, any material differences to our supply/demand
model (e.g., demand drops suddenly, or supply increases more rapidly than
we predict) may cause our valuation methodology to be inaccurate.
* Applied has undergone changes in its senior management structure, even
two-plus years out after installing a former Intel senior executive as
CEO & President. While our limited exposure to customer reaction
suggests a positive view to this change, we recognize the disruptions
such changes in senior management can cause within a firm and the
potential impact to operations and/or order flow.
* Applied is currently undergoing an extensive cost restructuring program
in an effort to align their infrastructure with their perception of
future business levels. Disruptions associated with this cost initiative
or a mis-estimation of potential future business levels could create
difficulties in Applied's ability to meet our forecasts.
* As the market share leader in multiple sub-segments of semiconductor
equipment, Applied is uniquely positioned to capitalize on inflections in
industry cycles. However, at their currently elevated share position, we
believe incremental share gains become increasingly difficult. While we
believe share shifts are largely stable at this stage, we recognize the
competitive pressure Applied faces from its smaller peers.
* Additionally, although we view AMAT's efforts to expand their service
business positively, we believe that the expansion in core
responsibilities risks alienating some customers who may view AMAT as
taking over too much of the market.
If the impact on the company from any of these factors proves to be greater
than we anticipate, the stock will likely have difficulty achieving our target
price.
Advanced Energy (AEIS--$13.13; 1S)
Valuation
We rate AEIS Buy, Speculative Risk (1S) with a $15 price target.
As the semiconductor industry undergoes secular shifts in the demand curve and
equipment lead times, our analysis suggests that cycles are becoming shorter
and with less peak to trough cyclical amplitude. This is evidenced by fewer
companies losing money in the downturn, but may also be characterized by lower
peaks and more focus on sustainable earnings across a cycle rather than a
subjective multiple placed on "peak" earnings. In this environment, we conclude
that the primary valuation focus should be on normalized, "cross-cycle"
earnings power.
When looking at recent trough trailing 12-month (TTM) EPS, reported numbers
suggest ($0.04) occurring in FQ2:05. However, we believe this understates true
trough earnings on a go-forward basis for two reasons: 1) interest expense is
now effectively zero given the retirement of both convertible bonds -- this
compares to ~$2MM per Q in historical quarters, and 2) margins have improved
dramatically on essentially flat revenue over the past several Qs as the move
to China has reset the cost structure lower. While we don't typically make
adjustments to TTM EPS in our cross cycle EPS calculation, for these reasons,
we feel a more accurate representation of the future cross-cycle (normalized)
EPS potential of this company would take these factors into account. If we did
not make these adjustments, we feel the trough EPS would be misleading. Thus,
while the reported trough TTM EPS is ($0.04), adjusting for these two factors,
we estimate trough TTM EPS would have been ~$0.45.
If we instead use this as our trough and average it with our estimated peak
rolling four quarter EPS estimate of $0.95 (FQ1:07), we arrive at a cross-cycle
EPS estimate of $0.70.
The S&P500 is currently trading at ~16x 2006 EPS. Although near-term
cyclicality in the semiconductor industry is likely to overshadow longer-term
growth rates, we continue to see the semiconductor industry growing at nearly
10% CAGR over the next five to ten years and AEIS should additionally benefit
from faster-growing end markets like flat panel. However, given the new
business model (China) and recent missteps in execution, we assign the market
multiple to our cross-cycle EPS estimate and arrive at a price target of ~$12.
Excluding the abnormal 1999 to mid-CY2000 timeframe, the ten-year historical
price to TTM sales is in the range of 1.0x to 3.0x, with the average being
2.4x. AEIS is currently trading at just 1x TTM sales, well below its
historical norm. On the plus side, AEIS has a lower cost structure than a few
years ago, but on the negative side, the margins are still nearly 1000bps lower
than 5 years ago. Thus, applying the ten-year average to our cross-cycle
revenue estimate of $380MM, we arrive at a price target of $20.
From a book perspective, AEIS has historically traded at an average multiple of
close to 4.0x (excluding the inflated 1999 to mid-2000 timeframe). Currently,
the stock trades for 2.5 times book value, near the bottom end of historical
range. We estimate AEIS will have ~$4.32 per share in tangible book value by
YE2005. On top of this, the company has an off balance sheet deferred tax
asset of ~$0.72. Thus, we estimate that adjusted tangible book value is ~$5.04
by YE2005. On the plus side, AEIS has a lower cost structure than a few years
ago, but on the negative side, the margins are still nearly 1000bps lower than
5 years ago. Thus, if we apply a slight discount to this long-term book
multiple of 4x and rather using 3.5x, are arrive at a price target of ~$18.
Because of the disparity in price targets, we prefer to use a 50/50 blend of
earnings and sales -- both of which capture the cross-cycle potential of the
company. This methodology is consistent with our chosen methodology for the
main comparables currently under coverage (BRKS and ASYT). Using this
methodology, we arrive at a price target of ~$16.13.
Using comparable companies, this implies a C2006 EPS multiple of ~17x based on
our estimate. This would make AEIS slightly more expensive than all key
comparables other than CYMI and MKSI. Because we prefer to try to remain
conservative given uncertainties surrounding the ongoing China transition, we
have instead chosen a $15 price target. This implies a C2006 EPS multiple of
~16x which puts it more in-line with the low-end of comparables.
Near-term market volatility and short-term trading patterns may cause the
expected total return to become temporarily misaligned relative to the hurdle
for this stock's fundamental rating, as defined under our current system. We
recognize that our price target is only modestly higher than the current price,
and will revisit our assumptions/inputs in the near-term as we get increased
visibility on front-end equipment order strength at big AEIS customers like
AMAT (reporting next week).
Risks
We rate AEIS Speculative risk primarily due to low earnings stability and, with
a Beta of 1.9, high stock price volatility. The following are key risk factors:
* AEIS derives the majority of its revenue from the highly cyclical
semiconductor industry and has exposure to other volatile markets such as
flat panel display. Although the semiconductor industry currently is in the
midst of an upcycle, any unexpected drop in semiconductor demand or
delays/cancellations in new fab projects or expansions could significantly
lower demand for AEIS products.
* AEIS revenue is highly levered to leading equipment maker AMAT (~25% of
overall sales). Though our analysis suggests that there has been no
appreciable share loss at AMAT in recent years, any downward shifts in share
at its leading customer could seriously hamper AEIS revenue growth and
profitability.
* Our model assumes a recovery in capital spending for equipment in C2006.
Any material difference in our capital spending or semiconductor
supply/demand models could cause revenue and earnings to be lower than our
expectations, which could negatively affect the stock price.
* The company also is subject to competitive pricing pressure. While AEIS is
well entrenched as the leading supplier of precision power supplies to the
semiconductor market, it has a lower market share in its mass flow control
business (~20%). Within that business, the company faces significant
competition from companies such as MKSI, Horiba/STEC, and Celerity. This
pressure can result in lost sales and can create pricing pressure in the
mass flow control division. Additionally, as its OEM customers look to
increase the proportion of their outsourced components, specifically in the
form of subsystems, the company faces the risk of share loss should it not
be able to offer its customers a complete solution similar to those being
offered by some of its top rivals.
* Many of the companies' products come under periodic pricing pressure from
customers such as AMAT. The move to China offsets much of this pressure and
we have assumed some pricing pressure in our margin assumptions, but if this
proves to be more severe than we have projected, there could be risk to our
margin assumptions.
* Additionally, the company is still subject to risks related to the
relocation of its primary manufacturing facility to Shenzhen, China.
Although this facility has now been operating for over one year, there are
still product lines that have not been transitioned from Fort Collins,
Colorado. Any delay in the successful transfer of these product lines could
result in increased costs that could negatively impact the stock price.
If the impact on the company from any of these factors proves to be greater
than we anticipate, the stock will likely have difficulty achieving our target
price.
ANALYST CERTIFICATION APPENDIX A-1
I, Timothy Arcuri, research analyst and the author of this report, hereby
certify that all of the views |
