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Applied Materials: Much Ado About Nothing
Analyst: Chris Bulkey (11/18/98)
So, Applied Materials (NASDAQ: AMAT) released fourth quarter earnings that exceeded analysts' sharply lowered estimates. Does this quarter mark a turnaround in its business? No.
Sure, a number of high-profile brokerages quickly upgraded their rating on the stock this morning, including Merrill Lynch, DLJ and Advest, after Applied reported earnings of $0.07 per share (excluding restructuring charges), ahead of the First Call estimate of $0.02.
But this was well below the $0.49 a share that Applied earned last year. Sales fell 47% to $673.2 million from $1.28 billion. This marks the fourth consecutive quarter that revenue showed a sharp sequential decline. Fourth quarter sales were nearly 50% lower than the first quarter's results of $1.3 billion.
Falling Gross Margins
Gross margins continued their descent, falling for the fourth straight quarter. Applied reported a gross margin of 42.3%, down considerably from the 48.1% in the prior year's period.
The company is also losing operating leverage as its sales base shrinks. Due to higher SG&A expenses as a percent of sales, its operating margin also fell for the fourth straight quarter. The reported number was 4.3% in the fourth quarter, a huge decline from the 22.5% operating margin in the first quarter.
Gross book-to-bill was a slim 1.02, down slightly from 1.07 last year. After adjusting for order cancellations and delays, net book to bill came in at .87, marking a modest improvement from the third quarter's gross book-to-bill ratio of .69.
The company bagged $684 million in orders during the quarter, a 13% increase sequentially. But they were down 50% year-over-year. What's more, the company's backlog continued its steady decline, coming in at $917 million, down from $1 billion in the third quarter and $1.4 billion at the end of the second quarter.
Higher DSOs
An indicator of the poor financial condition of many of its customers can be seen in the huge jump in days-sales-outstanding, or DSOs, which increased to 103 from 84. Anytime DSOs increase considerably it should raise a red flag as to the quality of the reported earnings.
One possible reason: Although Applied sells primarily to blue-chip caliber companies, 41% of fourth quarter sales were made in Japan and Asia, where weak economic conditions have left many companies unable to raise needed capital.
"Uncertain" Outlook
Management's guidance during the Wednesday conference call didn't build confidence either. In fact, CEO James Morgan was quite vague, offering comments like "the chip market appears to have bottomed," but adding, "the outlook for our business is uncertain."
The company would like to claim that Applied has passed a trough, but we may not have seen the bottom yet. The company expects to book $600 million to $675 million in new orders for the first quarter, furthering the downward trend.
For fiscal (October) 1998 Applied earned $1.15 per share from operations. For 1999 the consensus now stands at $0.56 per share. On the high end, Value Investors forecasts $0.80, while Needham & Co. expects Applied to earn just a penny.
At the beginning of calendar 1998 analysts were expecting around $2.50 for 1999. The outlook has obviously been tempered, as the estimate has come down nearly 80% since the beginning of the year. Considering the lack of visibility going into 1999, we think the $0.56 estimate has a good chance of coming down further.
Cost-Cutting
The upside surprise in the latest quarter was a matter of cost-cutting, due to a 15% workforce reduction and 10% cut in executive salaries. Jerry Dobson, portfolio manager of Parnassus Fund, which owns 400,000 Applied shares, confirms this notion. He states that "the cost cutting worked -- they earned more than I thought they would. They are well-positioned for the next upturn."
We agree that Applied is positioned as the dominant semiconductor capital equipment supplier with cutting edge technology that is driving the industry-wide push towards smaller line-widths (.25 micron and below). We do not, however, think that industry fundamentals have improved all that much. The consensus says there is still a lot of over-capacity in the semiconductor industry, as most chipmakers are operating well below full capacity.
DRAM prices have rebounded nicely since their August lows, but according to Hambrecht & Quist analyst Gus Richard, the improved pricing may be short-lived. He notes that Korean DRAM suppliers have recently ramped up production. When you couple more supply with a seasonally weak first quarter, DRAM makers are likely to slow their investment in new equipment.
Add to that the continued economic uncertainty in Asia and it is possible that more negative announcements regarding spending on new plants and equipment could re-emerge in 1999. Perhaps the combination of the above three factors is the reason that CEO Morgan has little to no visibility beyond the first quarter.
We think Wednesday's reaction to the earnings underscored the recent rally in Applied shares, which have climbed nearly 75% from their October low. Initially the stock opened up 1 1/2 points, but wound up falling back to a 3/4 point loss, as investors began to dig into the numbers behind the upside earnings surprise. It seems like investors bid the shares up over the past few weeks in part because they believe the Asian worries are now behind us and sales will rebound in 1999.
But, the lack of visibility into next year along with the continued margin pressure and huge jump in DSOs gives us no reason to predict a turn in Applied's business.
Based on the consensus estimate for this year, which may very well be too high, the shares are now valued at 68 times fiscal 1999 estimates, which is way too expensive for a company exhibiting negative profitability trends.
Bottom Line:
Applied dominates its industry and will again be attractive at some time in the future. So, while we do not recommend Applied Materials as a short candidate, we advise investors to look elsewhere for attractive stocks. |
