Applied Materials faces a tough second half
Applied Materials saw strong demand for its products in Q1, but the last half of the year could be rough if downturn fears materialize.
By Amanda Cantrell, staff writer

NEW YORK ( - By most indications, Applied Materials is sitting pretty.

The company, which is the number one supplier of semiconductor manufacturing equipment in the world and also sells related services and software, sports a price-to-earnings ratio of 19.7 -- lower than the 22.1 ratio of its closest publicly-traded competitor, KLA-Tencor (down $1.48 to $47.64, Research).

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Applied Materials (down $0.38 to $18.05, Research) reported a 22 percent rise in new orders in its fiscal first quarter, and recently upped its dividend to $0.05 cents a share. In addition, it authorized up to $5 billion in share repurchases over the next three years ending in March 2009.

But despite all these positives, its shares are still down 11 percent from a high of $20.79 in January.

Bearish analysts say this has less to do with the company itself than the forecast for the semiconductor industry as a whole, which they believe is primed for a slowdown in the second half of the year. While the semiconductor equipment industry reported growth of about 20 percent in the first quarter, Stuart Muter, an analyst for RBC Capital Markets, thinks it will slow to 5 to 10 percent for the current quarter, which he said is why these stocks have pulled back.

"That's still not a lot to get excited about," he said of the current quarter growth forecast.

Dominant but vulnerable

Applied Materials' customers include chip makers such as Intel (Research), Samsung and Texas Instruments (Research), as well as companies who make semiconductor integrated circuits and manufacture the flat-panel displays used in monitors and TVs.

"We are in every semiconductor [fabrication plant] in the world and every flat panel fab in the world," said Michael Splinter, CEO of Applied Materials.

Because of that dominance, however, Applied Materials is especially vulnerable to fluctuations in the semiconductor market. And right now, many sell-side analysts think the semiconductor industry will face a downturn in the second half of 2006.

"Orders for Applied have grown between 15 and 20 percent for the past couple of quarters, and we think they will remain relatively strong through the July quarter," said Timothy Summers, an analyst at Stanford Financial Group. "But we think it will slow and perhaps dramatically slow in their October quarter."

Summers said he thinks the slowdown will be industry-wide, not specific to Applied Materials. And any reduction in chip demand will of course reduce demand for Applied Materials' products.

But CEO Michael Splinter told investors during the company's most recent quarterly earnings call that he thinks the company is in for a "sustained upturn." Splinter told he thinks the pessimism about the semiconductor is overblown, citing growth in the PC market as an example.

"[PC's] were supposed to go to single-digit growth, but that hasn't happened," said Splinter. (Industry tracker IDC estimates that growth in worldwide PC shipments will come in at about 10.5 percent this year.)

He adds that the release of Microsoft's (Research) newest version of its Windows operating system, Windows Vista should spur demand for PCs, which benefits chip makers, and in turn, semi equipment manufacturers. Vista will be available for business customers in November and for consumers in early 2007.

While that may spur demand in the next year, analysts say that demand for the next two quarters remains unclear.

Downturn not a given

Suresh Balaraman, an analyst with ThinkEquity Partners, said that while it's possible the current quarter could be "lumpy," he doesn't share the view that the semiconductor market is headed for a downturn.

Balaraman said Applied's bookings data, or the dollar value of contracts signed for new business, appears to be strong over the next two or three quarters. And he says that since chip makers are currently operating at capacity which is expected to stay consistent, there is little danger of the kind of spending cutbacks that could hurt equipment makers like Applied.

Applied's Splinter said the semi conductor equipment industry is a roughly $30 billion market; he estimates that related services constitutes about $11 billion, while the market for equipment for making flat-panel monitors and TVs is another $5 billion.

Splinter said Applied, which is expected to record $8.7 billion in revenues for its 2006 fiscal year ending in October, has a chance to gain market share, thanks to increasing demand for flat-panel displays and new trends such as multi-core processors, which help PCs run faster while consuming less energy.

It's also got new products in the pipeline to advance the chip manufacturing process, according to Splinter. Also, Applied's services business is also growing, which Splinter says will help mitigate some of the volatility in revenues from the equipment business. He estimates that the services business now accounts for between 21 and 25 percent of Applied's total sales.

Splinter adds that the company has taken a disciplined approach to cash management to protect itself in the event of a downturn, and will continue buying back shares.

"We have been producing huge amounts of cash, we reduced our number of shares by 100 million; we are [paying dividends] and buying aggressively today," he said. "We think the stock is a great investment for the company as well."

However well-positioned the company is for the long term, the stock's performance in the near term hinges on the industry's outlook for the second half of the year, which is far from certain, said RBC's Muter.

"Near term, I see plenty of risk in holding semi-equipment stocks in terms of the slowing second quarter growth rate," he said, adding that he thinks the declines in growth will continue through the third quarter.

None of the analysts interviewed for this story own shares of Applied Materials.


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