Investors Are Betting Too Much on Applied Materials

TheStreet.com

NEW YORK (TheStreet) -- Shares of semiconductor giant Applied Materials are still soaring following the company's all-stock deal to merge with Tokyo Electron.

What this means is Applied Materials, which is the world's largest chip equipment maker with a $21 billion market cap, is joining forces with the world's third-largest sector rival with an estimated market cap of $10 billion.

The question is what exactly did Applied Materials accomplish with this deal?

Given the level of business erosion through which Applied Materials has suffered, including a 16% revenue decline in the August quarter, picking off Tokyo Electron makes sense on many levels. Still, while the stock has done well, up more than 50% for the year to date, I haven't seen the sort of outperformance needed from Applied Materials that would support such investor optimism.

The company already generates roughly 70% of its business from such areas as China, Japan and Taiwan, among others. It is clear management wants to secure its market position in those regions. My issue, however, is this deal does not address pressing concerns about system orders, which have been on the decline in the trailing 12 months.

Plus, with weak financial results coming out from smaller players including Ultratech and MKS Instruments , there are no signs that the next order cycle, or for that matter the next several cycles, will show much (if any) improvement.

Granted, things have been "less bad" of late. But let's not forget that in the August quarter Applied Materials posted a 12% sequential decline in system orders, of which there was a 50% decline in the all-important foundry business, leading to a 23% year-over-year decline in net income. A case can be made that Applied Materials is beginning to lose share to nimbler rivals such as Lam Research , which has consistently grown both revenue and profits.

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

I'm not suggesting that shareholders should immediately bail on the stock. But I do think it's a mistake to completely dismiss some of these factors, including a possible language barrier that may slow some merger processes. Along those lines, I don't believe that management has shown enough interest to grow its U.S. business, which accounts for less than 20% of the company's sales and may fall further once this deal closes.

In fairness, I don't want to completely discount some of the possible benefits. As a value investor, I place a strong emphasis on the bottom line. So it's also encouraging that, according to recent estimates, the combined companies are expected to save roughly $500 million per year in operating expenses. Without question, the lowered capital expenditures should help bolster the bottom line.

It's also a strong positive sign that management has already committed to buying back $3 billion worth of the company's stock once the Tokyo Electron transaction is final. But again, these are temporary fixes. I'm more interested in seeing if Applied Materials can get back to growing revenue and profits on an organic basis.

While the CEO change and bringing on Tokyo Electron may have served as near-term catalysts for the recent stock hike, I think investors need to pause here and study everything that is going on. Ultimately, it will be higher orders and shipments that will drive this stock.

Unfortunately, as shown by the foundry order reduction, most if not all of the revenue growth on which Applied Materials relies is predicated on semiconductor capital spending. In this sector, that's not something Applied Materials or any other company, can control.

Until revenue and profits begin to show meaningful organic growth, I would take my profits now and wait for a lower entry point.

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

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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