Key Concerns Impacting Applied’s $12 Valuation

by Trefis Team
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Applied Materials
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With macro headwinds leading to soft demand for consumer products, most semiconductor manufacturers have reduced their capital spending, which in turn led to a drastic decline in Applied Materials (NASDAQ:AMAT) equipment sales. Witnessing a more than 40% reduction in its semiconductor equipment sales, the company posted a 31% decline in its Q4 2012 revenue and registered a marginal decline in gross margins due to lower sales, inventory reserves and lower factory utilization.

With a significant fluctuation in demand, Applied’s silicon systems group was the worst hit in Q4 2012, though the weak market environment persists in display and solar segments as well. However, Applied believes that its orders bottomed out in Q4 2012 and expects the situation to improve 2013 onward.

We remain optimistic on Applied’s long-term prospects as we think that the accelerated changes in device technology and the adoption of new materials in the industry will fuel its top-line growth. Additionally, we believe that the increasing complexity in manufacturing processes provide an added opportunity for growth.

Here we highlight certain key trends and concerns prominent in the company’s Q4 2012 earnings results.

See our complete analysis of Applied Materials here

Decline In Capital Spending By Semiconductor Manufacturers

Applied’s semiconductor manufacturing systems are used by integrated device manufacturers and foundries to build and package memory, logic and other types of chips. Weak market conditions have caused pullbacks in expansion plans throughout the industry as manufacturers adjust their production levels to match the end-user demand. Applied witnessed weaker than expected demand in its semiconductor equipment business in 2012, primarily among foundry customers.

While weakness in the global PC market is the primary reason for declining investments, the robust growth in smartphones and tablets is driving innovation and could fuel demand in the coming quarters.

1. Slowdown In PC Shipments – The slowing enterprise market, consumer softness in mature markets (US and Western Europe), slowing demand growth from emerging markets, operating system transitions and cannibalization by tablets are some of the main factors leading to the current slump in PC shipments. Research firm IDC predicts the global PC market to grow by a mere 0.9% in 2012. [1]

Applied forecasts negative PC growth for the current year. However, it feels that the launch of Windows 8 OS and the introduction of new touch-enabled ultrabooks can fuel PC demand thereon, leading to a potential upside for both logic and DRAM investment.

2. Mobility Trend To Drive Innovation – With robust growth in the smartphones and tablets market, mobile devices are slated to fuel the future growth in the semiconductor industry. The global sales of media tablets are estimated to increase by 98% this year, from 60 million units in 2011 to 119 million units in 2012, and reach close to 370 million units by 2016. [2] On the other hand, while the global mobile phone sales have registered a slight decline (-2%), smartphone sales have shown a robust growth (44%) so far this year. [3] [4] Thus, the mobility trend remains the biggest influence on semiconductor industry spending.

Intense competition in the mobile market is leading to faster innovation and the high demand of application processors is driving foundries to build out their 28-nanometer capacity and ramp investment for the 20-nanometer node. The company considers the above trends to be favorable as they create spending shifts that are favorable to its business.

Emerging Markets & Mobility To Fuel Display Revenue

Despite persistent weakness in TV investment and low revenue levels, Applied’s display business continues to execute well and remain profitable in every quarter. Witnessing a restoration in the demand supply situation, the company claims that its equipment orders are picking up. There are two factors responsible for the same -

- Strengthening demand from emerging markets.

- Growth in smartphones & tablets: Mobility related business constitutes more than 80% of Applied’s display revenue and Applied expects robust investments for high-resolution mobile displays and touch panels to further fuel its revenue in the future.

Restructuring The Solar Business

The solar equipment market is dependent on sales of solar PV and thin-film products to solar energy companies and currently the industry is suffering from low demand coupled with excess manufacturing capacity. Applied’s EES revenues were down 19% sequentially in Q4 2012. While the company claims that the growth in demand is starting to consume the excess manufacturing capacity in the solar industry, it maintains a cautious approach as the investment in new capacity remains low.

Having witnessed a steep decline in orders at the start of the year, Applied announced a restructuring plan for its EES business in Q3 2012 to lower its cost structure and the operating breakeven level to approximately $500 million. As the demand in the solar industry remains sluggish, it plans to take additional steps to reduces its cost base and minimize the associated losses.

However, we remain optimistic on the long-term prospects of this segment as there is bound to be an increase in demand for solar power use with growing awareness about the benefits of renewable energy combined with declining costs.

Our price estimate of $12.02 for Applied Materials, is at a premium of over 10% to the current market price.

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Notes:
  1. IDC Lowers PC Outlook As Shipments Decline In Second Quarter Ahead Of Fall Product Updates, IDC Press Release, August 23, 2012 []
  2. Gartner Says Worldwide Media Tablets Sales to Reach 119 million Units in 2012, Gartner Press Release, April 10, 2012 []
  3. Gartner Says Worldwide Sales of Mobile Phones Declined 2 Percent in First Quarter of 2012; Previous Year-over-Year Decline Occurred in Second Quarter of 2009, Gartner Press Release, May 16, 2012 []
  4. Gartner Says Worldwide Sales of Mobile Phones Declined 2.3 Percent in Second Quarter of 2012, Gartner Press Release, August 14, 2012 []
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