Applied Materials Must Apply Itself

NEW YORK (TheStreet) -- The last time we talked about Applied Materials (AMAT), shares of the semiconductor giant were (then) soaring following the company's all-stock deal to merge with Tokyo Electron. The Street salivated over the idea that Applied Materials, the world's largest chip equipment maker with a $20 billion market cap, was joining forces with the world's third-largest rival in Tokyo Electron.

Even so, I didn't believe Applied Materials' risk/reward ratio was any more attractive than it was before the deal. At least not to the extent that it justified the 10% jump in the stock.

In the October article, I said:

"Applied Materials investors who are now bidding up these shares solely on the basis on this deal don't fully understanding the risks that still remain here. Not only must the company execute to synergize both operations, Lam Research (LRCX) and Ultratech (UTEK) are not going to just sit idle and allow Applied Materials to sort things out. And when you consider that the company just installed a new CEO in Gary Dickerson, the uncertainties begin to pile up."

At the time, investors reacted as if I was dousing their flame with misguided bearishness. But aside from the execution risks, Applied Materials was already suffering weak organic growth due to (among other things) fledgling order levels. For a stock that was already trading on high expectations (its P/E was 55 points higher than the industry average), the Street never could explain with any clarity what this deal achieved beyond Applied Materials picking off a rival.

Arguments were raised that suggesting management was planting its feet even further in areas like China and Japan, where Applied Materials already generates close to 70% of its revenue. But these weren't exactly booming economies. Plus, given the sluggishness and the overall weakness in chip stocks due to slumping ASPs (average selling prices), management could have waited for a better timing. This deal did not fix the company's underlying operational deficits, either.


Fast-forward three months later and these shares are lower than where they were following the initial surge. The Street is now seeing exactly what I reported three months ago. Analyst Mehdi Hosseini with Susquehanna Financial Group, who reiterated Applied Materials with a "negative" rating, recently released a note saying the following:

"We expect the SCE [semiconductor capital equipment market] to give back the gains of [calendar year 2013] because of consensus expectations that are too aggressive/unrealistic, rich valuation, with [capital expenditures] commentary to disappoint during 4Q conference calls."

I'm not going to forecast SCE growth projections for the current year. It goes beyond the scope of this article. I don't believe these projections can hold water from one quarter to the next. After all, this is the reason we're are discussing this stock and the irrationality it portrayed. The outlook three months ago was favorable. Now it's not.

I do agree with Hosseini's assessment of Applied Materials, for no other reason than the fact that this business has showed some meaningful signs of erosion over the past couple of quarters. Yet the stock still posted more than 40% gains in 2013. The company, meanwhile, has never been able to justify this level of optimism.

Wednesday, management will get another chance when Applied Materials reports fiscal first-quarter earnings results. The Street will be looking for 22 cents in earnings per share on revenue of $2.13 billion, which would represent a 35% year-over-year jump in revenue. This would be a noticeable improvement following the company's 21% revenue jump in the November quarter.

The thing to remember is that this is the level of growth the Street is paying for. And if the company only meets expectations, these shares will get punished. What's I'm more interested in is what management will regarding to new products, especially in an environment where process technology is forever changing.

It would also serve the company better if management were to show more interest in growing its U.S. business (which accounts for for less than 20% of sales). All told, I still can't recommend this stock until revenue and profits show meaningful organic growth and the company clearly outlines its positions for the future.

At the time of publication, the author held no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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