AMAT; Great Quarter, Our Concern Is The Risk/Reward
Salomon Smith Barney
Wednesday, May 19, 1999
--SUMMARY:--Applied Materials--Semiconductor Equipment
Solid 2Q99 with EPS/bookings/revenue surprise. Raising FY99 est. from
$1.24 to $1.56. Adjusting FY00 down to $2.18 from $2.33. Target of $76
unchanged, or 31x cal. 00 est. of $2.44, or 10% premium to S&P (peak val).
Good-strong DRAM/foundry/logic spending almost completely factored into
expectations.In the context of 3-3.5 months backlog, falling DRAM prices,
15% and 50% wafer capacity additions by TSMC and UMC, and iron resolve
on the part of logic companies to control cap. ex., the question we raise
is the risk/reward.
Maintaining 2H rating. Proactively putting forth our concerns, when the
stock is still strong.
--EARNINGS:-----------------------------------------------------------------
FYE 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year
Actual 10/98 EPS $0.52A $0.37A $0.17A $0.07A $1.14A
Previous 10/99 EPS $0.11A $0.32E $0.40E $0.41E $1.24E
Current 10/99 EPS $0.11A $0.36A $0.52E $0.57E $1.56E
Previous 10/00 EPS $0.42E $0.55E $0.63E $0.73E $2.33E
Current 10/00 EPS $0.42E $0.49E $0.58E $0.68E $2.18E
Previous 10/01 EPS $N/A $N/A $N/A $N/A $N/A
Current 10/01 EPS $N/A $N/A $N/A $N/A $N/A
Footnotes: EPS are fully diluted.
--FUNDAMENTALS:-------------------------------------------------------------
Current Rank........:2-H Price 05/18/99......:$63.13
Prior Rank..........: Target Price........:$76.00
P/E 10/99...........:40.5X 52 Wk Price Range...:68.68 - 22.37
P/E 10/00...........:29.0X Proj. 5yr EPS Grth..:25.0%
Return on Equity 98.:19.70% BookValue...........:$0.00
LT Debt-to-Capital..:11.91% Dividend............:$N/A
Revenue 1999........:$4850.00 mil Yield...............:N/A%
Shares Outstanding..:378.00 mil Convertible.........:No
Mkt. Capitalization.:$23863.14 mil Hedge Clause(s).....:
Comments............:
--OPINION:------------------------------------------------------------------
Overview
As expected, Applied Materials delivered a "Michael Jordan" like
quarter, with revenues/bookings/earnings better than expectations. On
the upside in a cycle, the company can deliver earnings beyond one's
wildest dreams - our 3Q99 estimate is revised upward from $0.40 to
$0.52. However, while the stock still benefits from a "linear
extrapolation" strength over the next 1 month, the question that we want
to pose to the market is the risk/reward. We believe that a majority of
the upside due to good-strong DRAM/foundry/logic spending is already
factored into expectations. However, are current expectations factoring
in 1) Higher unpredictability and "down to the wire" quarters due to
3-3.5 months backlog, 2) DRAM pricing declining and capacity expansion
accelerating, 3) TSMC and UMC increasing wafer capacity by 15% and 50%
with a brand new WSMC (32k wafers/month) coming on-line, and 4) an iron
resolve on the part of logic companies to control cap. ex ??? We do not
think so.
We see airpockets ahead as the market understands how to value the "new
Applied and the new equipment industry", which instead of having 2 year
up-cycles and 2 year down-cycles, will probably see 3 quarter spurts and
2 quarter corrections. Our downgrade on Monday was a proactive stance to
pose these questions to the market, while the equipment sector is still
strong. We believe that these are short term (3-6 month) concerns,
because even though we may lose the DRAM cylinder, the logic/foundry
cylinders should continue to do well, however, it is still left
unanswered as to whether the market will clearly understand this or react
as if we are beginning a cyclical downturn at the first sign of an order
perturbation. Long term, this is a cyclical growth stock and is one of
the best run, best managed equipment companies with a spectacular product
set and hence our 2H (Outperform, High Risk) rating. We summarize the
positives and negatives from the call followed by a discussion of the
quarter.
Positives From The Call.
Lower DRAM content - It was reassuring to see DRAM content down to 28% of
orders or $390 million. This is a simplistic assumption since the total
order intake also includes service, however, since service orders can
also be bouncy (as we saw in the last downturn), it is a good
approximation. This is lower than our expectation of $500 million.
However, it is significantly higher than July-1998's $120 million.
Cautious Conservative Stance - Implicitly, we believe that Applied's
management recognizes that given the "vertical take-off" recovery,
there is a good likelihood of perturbations and is taking all the correct
steps such as minimal head count additions to manage the company in a
dynamic environment.
The use of backlog as a competitive weapon - Given the efficiencies
achieved by cycle time reductions, the company is reducing its backlog
from the traditional 4-4.5 months to 3.0-3.5 months. When we were in
Asia two weeks ago, a quick equipment delivery time was mentioned as one
of the most important characteristic of the "JIT" world going forward.
It is good competitive weapon since Lam Research/Novellus Systems/KLA
Tencor all operate with a 4+ months backlog. There are negative
ramifications that we will address in the next section.
Excellent Product Set - With Applied's impeccable record over the last
15 years, we often take product excellence for granted, but even then,
the 1999 product execution is an eye-opening surprise. We estimate that
Applied Materials will grow 45% in calendar 1999, while the industry will
grow 16% (Due to the widely varying definitions on calendarizing an
October fiscal year company, our figures may not exactly match any other
assumptions). The only negative one can draw from this is that "How can
2000 be any better". In many cases, Applied Materials is the market -
CMP, PVD barrier, RTP and its explosive spurt this year may not leave any
appreciable market share gains next year.
Negatives.
Volatility - While a 3.0-3.5 month backlog is a competitive weapon, this
implies that there is no cushion - "This quarter's bookings are next
quarter's revenues". Given the explosively cyclical history of the
equipment industry, we believe that the market may first have a negative
reaction, before it digests the long term market share gains and the
stability provided by this model.
300 mm - Every additional day 300 mm gets postponed, the prior 300 mm
products of 1997 will require more rework to make them compatible for the
0.13 micron generation of tomorrow. When these products were initially
designed in 1997, the target node was 0.18 micron. More importantly,
given the breadth of products and the high costs of silicon wafers ($800
plus), we believe that 300 mm will impose a significant R&D burden on the
equipment companies. With semiconductor companies requiring 1-2 years of
debugging before launching 300 mm production lines, there is also little
likelihood of "immediate" 300 production revenue growth. The pickup in
R&D without any meaningful impact on revenue can prove to be tricky at
the current valuation.
Year-to-year Growth Figures Are Sounding Alarm Bells !!! Applied
Materials expects the wafer fab equipment market to grow from $15.5
billion to $18 billion, a growth of 16%. While it is true that the
semiconductor industry is cutting back on "bricks and mortar" and other
fringe cap. ex., the root cause of overcapacity can be traced to the
wafer fab equipment market. SSB semiconductor analyst Jon Joseph is
forecasting semiconductor industry growth rates of 12% in 1999 and 20% in
2000, however, the wafer fab equipment market growth rate has already
exceeded the growth rate of the semiconductor industry in 1999. This
happened previously in 1995 and 1996 causing the terrible downturns of
1996 and 1998. We believe that this time it will only be an air-pocket
due to 1998 (wafer fab equipment down 23%, when the semiconductor market
contracted 8%).
AMAT Announces 2Q99 Above Expectations.
Applied Materials reported an excellent 2Q99, with earnings of $0.36
versus our estimate of $0.32 and consensus of $0.27. Sales increased 51%
sequentially to $1.12 billion and were appreciably higher than our
estimate of $1.05 billion. This was the largest quarter-to-quarter ramp
in the company's history and both sales/orders improved throughout the
quarter. Gross margins of 46.3% increased 310 basis points sequentially,
and were 80 basis points below our estimate of 47.1%. The increase in
gross margins was due to better overhead absorption and lower fixed costs
(fewer manufacturing personnel and lower facilities costs) due to the
restructuring in 4Q98.
Across The Board Strength In Orders.
Orders of $1.39 billion (up 35% versus $1.03 billion in 1Q99) were
slightly above our estimate of $1.35 billion. Book-to-bill was 1.24
versus 1.39 in 1Q99 and backlog at the end of the quarter increased to
$1.36 billion from $1.15 billion in 1Q99. The strong bookings were driven
by both capacity/technology buys in logic/DRAM and particularly by
foundries. Purchases for 0.25 micron and below comprised the majority of
orders, with 0.18 micron buys representing 38% of orders (vs 25% in
1Q99). Orders improved sequentially for all regions with North America
comprising 30% of new orders, Europe-14%, Japan-17%, Korea-8%,
Taiwan-25%, and SE Asia/China-6%. By order size, 26 customers placed
orders for over $10 million (vs. 21 in 1Q99), 5 orders were over $50
million, and 2 orders were over $100 million.
Terrific Operating Leverage
The restructuring undertaken in 4Q98 resulted in good operating expenses
control. Operating expenses increased by only 19% sequentially versus a
51% increase in sales which led to terrific operating leverage. As a
percentage of sales, operating expenses declined 780 basis points
sequentially to 29.0% from 36.8% in 1Q99. Selling, general, and
administrative expenses increased 20%, from $132 million to $158 million,
due to increased spending on information system upgrades and increased
salaries. R&D expenses increased by 18%, from $141 million to $166
million, due to the copper and other 200 mm development programs. SG&A
expenses were 14.1% of sales compared to our estimate of 15.0% and R&D
expenses of 14.9% were below our 16.0% estimate. As a result of the lower
operating expenses which was partially offset by a lower gross margin,
the company reported an operating margin of 17.3%, 120 basis points
higher than our 16.1% estimate.
Balance Sheet Continues To Improve
Applied continues to improve its balance sheet as cash increased to $2.02
billion from $1.92 billion. Accounts receivable increased 37% to $920
million (below the 51% increase in sales) while DSOs declined to 74 days
from 81 days. Inventories were well controlled, increasing only 5% to
$578 million despite the large increase in sales, which illustrates the
benefits the company is achieving from its lean manufacturing
initiatives. Book value per share amounted to $8.56 while cash per share
stood at $5.10.
Adjusting FY99 upwards and FY00 downward And Maintaining Our Price Target
Of $76.
We are raising our 3Q99 revenue forecast from $1.15 billion to $1.35
billion and our 3Q99 earnings estimate from $0.40 to $0.52. Our full
fiscal year 1999 revenue forecast goes to $4.6 billion from $4.09 billion
and our FY99 earnings estimate goes to $1.56 from $1.24. We believe that
we are pulling forward 2000 growth into 1999, and are adjusting fiscal
2000 revenue forecast down to $5.05 billion from $5.4 billion and fiscal
2000 earnings estimate to $2.18 from $2.33. These are very respectable
year-over-year figures, in spite of factoring in a digestion period in
1Q00 and 2Q00. However, the market has always valued these stocks in a
linear extrapolation mode, and we believe that the expected air-pocket in
late 1999/early 2000 is not factored into expectations. We maintain our
long term price target of $76, or 31 times our new calendar 2000 earnings
estimate of $2.44 (roughly a 10% premium to the S&P next calendar year
earnings multiple, which is the 1997 cycle valuation peak).
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