Erik Kobayashi-Solomon: Hi. I'm Erik Kobayashi-Solomon, one of the editors of Morningstar's OptionInvestor. Today, it's my great pleasure to welcome Andy Ng to talk about Applied Materials. Andy Ng is a senior equity analyst covering semiconductor equipment companies here at Morningstar.
Andy, thanks for coming.
Andy Ng: Sure.
Kobayashi-Solomon: So, we had written a covered call idea on Applied Materials earlier in May, and just after Applied Materials reported earlier this week, you brought down the fair value estimate. The first thing I wanted to ask is just what did you hear on that conference call that made you want to decrease your fair value estimate?
Ng: Let's just take a step back a little bit. The chip-equipment industry is actually firing on all cylinders right now. But, during the call, management noted that some chipmakers have been a little more cautious about ordering or buying new equipment and they've seen some order push-out. So, part of the reason why we lowered their fair value estimate is because of some near-term uncertainty. Secondly, so far during this latest industry upturn, Applied's profitability has been below our forecast on the gross margin side. So, the main reason why we lowered the fair value estimate was to account for lower gross margins than we'd expected.
Kobayashi-Solomon: Let's talk a little bit about that and how it deals with competitive dynamics a little bit later. I want to get back to the order push-outs. Does this have to do with the Japanese tsunami and all the problems that Japan has had?
Ng: Yeah, that's one of the factors. Definitely, when you look around the space, that's something that managements have talked about. And the other thing that Applied noted was this rising economic uncertainty. It seems like chipmakers are becoming a little more cautious. In the last five quarters, Applied's chip-equipment business has seen orders go up from $1.1 billion to $1.7 billion, and sales for the overall company has gone from $1.8 billion to $2.9 billion.
Kobayashi-Solomon: I see. So, a healthy increase.
Ng: So, given that we're in this upturn, but with the Japanese disaster and economic uncertainty, the chip maker customers seem to be, I guess, becoming a little more cautious.
Kobayashi-Solomon: I see. Maybe the Japanese disaster just kind of underscored some free-floating anxiety among the chipmakers or something. So, the last time we talked about Applied was about a year ago, and this was actually a bullish call idea, that is buying calls on Applied. At that time you said, the chipmakers are going great guns. There's a little bit of chip-equipment supply left in the system, but once that gets used up, Applied is going to be a big beneficiary. What has happened in that intervening year?
Ng: That has happened. Like I just said earlier, orders have jumped for chip equipment. The chip-equipment space has gone from recovering from a severe downturn in 2009, to firing on all cylinders. So, Applied has benefited.
Kobayashi-Solomon: But they just didn't translate into a stock price increase?
Ng: When you look at Applied stock, it actually did get up to almost $17. You have to keep in mind, these stocks tend to fluctuate with the cycles. So, even though things are going really well right now, just the fact that there's some uncertainty and some fears that this upturn might not be sustainable has caused the stock to drop a lot like in the last couple of weeks.
Kobayashi-Solomon: Let's get back to the competitive dynamics that you mentioned. You mentioned that you're worried that the profitability of Applied is not as good as you had forecast. What's the root cause behind that? The firm's not facing some sort of competitive threat in its cash-cow chip-equipment business, are they?
Ng: I think, it's two factors. First is--you'll probably ask me about this later--but on the solar-equipment side, the margins aren't as good. I think one of the reasons is because it's still an emerging business. So, the margins there have been sort of masking the main chip-equipment businesses' gross margins.
Secondly, you have to keep in mind, Applied's been trying to gain market share in the chip-equipment space, and so, I think part of that has caused competition to increase a little more, and Applied in the past has been known to lower prices to capture some market share.
Kobayashi-Solomon: I see. Basically, the people that they're competing with or the companies they're competing with are usually smaller and more specialized firms.
Kobayashi-Solomon: Specializing on a certain piece of equipment for a certain step in the chipmaking process.
Ng: Yeah. Applied has a pretty broad product portfolio compared with everyone else. So they tend to compete against specialists like KLA-Tencor, Lam Research, Novellus Systems, and so on.
Kobayashi-Solomon: So, what you're saying then is that they're throwing some of their weight behind, let's say, lowering prices, trying to capture market share from some of these specialized firms?
Ng: In the past, Applied has done that, and we think that that might be happening today because they have been gaining market share. Keep in mind, they had lost some market share several years ago, so in the past two years, their focus has been trying to win back some of that market share. But, it's not just pricing, it's also technology and trying to get your equipment designs into the latest manufacturing technologies, and they've been successful in doing that as well. So, it's not just pricing; it's a lot of other things, too.
Kobayashi-Solomon: OK, so let's turn now to solar because you know that I hate the solar business. To me, Applied has a beautiful high-operating-margin business in the chip-equipment space. I don't understand why it is throwing so many resources and management skill behind the solar business. Can you get me more comfortable with that?
Ng: Sure. Solar, actually until several quarters ago, solar was not profitable, it was losing money. They restructured it several quarters ago. They had supplied equipment for thin-film as well as silicon-based solar equipment. So, these are two separate types of technologies. The thin-film portion of the business was actually losing a lot of money, where the silicon-based part of the business was profitable. So, essentially, they shut down the thin-film portion of the business. And so what they've been left with now is the silicon business, and that's actually profitable.
Kobayashi-Solomon: That silicon business fits in better with Applied's chip-equipment business, right?
Ng: They both fit in well actually.
Kobayashi-Solomon: Is that right?
Ng: Yeah. They both share common technologies with semiconductor manufacturing, but when you look at the silicon side, the business Applied has left now is actually profitable. Profitabilitywise, like when you look at margins and returns on invested capital, it may not be as profitable as Applied's main business. But I think you have to keep in mind that potentially this is a massive opportunity for Applied. So, the solar market is going to grow, and the equipment side is potentially just a really big opportunity for Applied. Even though the profitability is lower, ultimately, it can be beneficial to the company.
Kobayashi-Solomon: The thing that I worry about is that Applied is just kind of buying revenue when it is acquiring companies. Or the company is getting some fast revenue growth, but that's not really translating. I mean, even in the best cases, that solar business is making kind of single-digit margins. Do you ever see a time where it's really, let's say, making teens margins or 20% margins or something?
Ng: Well, I think there are a couple of things I want to talk about. First is, Applied actually is the biggest solar-equipment supplier today. It buys companies, and it has taken advantage of these acquisitions it has made. So it is the biggest equipment supplier now.
Secondly, yeah, if this thing can scale, absolutely it could become more profitable for Applied, but at the end of the day, it's all about risk and reward, I guess, especially in the technology space. So, Applied is taking the risk, and whether the reward comes, we probably won't know for a while because with the way things are now, it's probably going to take a while to see whether Applied is ultimately successful.
Kobayashi-Solomon: To see if solar really works out?
Kobayashi-Solomon: OK. So this leads in really well to what I want to ask about the downside. Right now, so we had recommendation to buy calls on Applied. I've kind of given up on that, but then we also had this covered call idea, which is basically selling downside insurance on Applied. So, what I'm interested in is that downside piece. What is your downside scenario for Applied, and how likely do you see that and how different is that from today?
Ng: In our downside scenario, our fair value estimate would be $15 per share. This downside, we're basically projecting slower industry growth of 5% annually during next five years versus our current projection of 7% annually during next five years. So, what would lead to this would be just slower global semiconductor consumption and maybe a slower technology transition is down. At 5%, you're pretty much you're…
Kobayashi-Solomon: Kind of a GDP plus kind of a business right?
Ng: Yeah, you're significantly lower than what chip manufacturing activity has been. So, that would be a pretty pessimistic growth rate. When you look at the profitability side, when you look at Applied's profitability, it tends to fluctuate with the industry cycles, as well. So, on the operating margin front, in this scenario, we project mid- to low-teens operating margins.
Kobayashi-Solomon: Which is historically really low for Applied?
Ng: Which is low. This is the type of margins you get when business conditions are slow. So, in such a scenario, we're taking fairly slow business conditions, not the worst because when things are really bad, they've lost money before, but taking pretty slow business conditions and extrapolating in the long run.
Kobayashi-Solomon: I see. Andy, thanks for explaining this. I know it's a complex story and a complex company, but I appreciate you coming and talking to us.
Kobayashi-Solomon: Thank you for joining us. Please stop by the Morningstar OptionInvestor website, where you'll find many more great ideas of how to manage risk in your portfolio.