Can Applied Materials Sustain Momentum in the Semi Cap Wars?

The slow-moving merger of Applied Materials Inc. (AMAT.O) and Tokyo Electron Ltd. (8035.T) is a potentially game-changing event, merging two of the largest players in the semiconductor equipment industry. Check out their market caps – $25 billion for AMAT and $11.3 billion for Tokyo Electron. The business itself is evolving, as new technology transforms current manufacturing equipment. In this environment, it’s important to understand how appealing Applied Materials may be to potential new shareholders.

Over the past few years, AMAT has announced some major changes, including a new CEO, Gary Dickerson, and CFO, Robert Halliday, in 2013. These former heads of Varian Semiconductor Equipment Associates (VSEA.O^K11), acquired by AMAT in November 2011, have a strong track record of market share expansion, improving quality of earnings, inventory turnover, and cash generation. On Sept. 24, 2013, as reported in this Reuters story, AMAT said it would merge with Tokyo Electron through an all-stock deal that would give AMAT shareholders 68% ownership.

On July 7, 2014, the newly formed company name, Eteris, was announced; however the deal has been held up due to issues related to approval from Chinese regulators. It’s expected to be completed in the second half of 2014.

Exhibit 1: StarMine Alpha Model Indicator Highlights for AMAT

Source: Eikon

Institutional favorite

Applied Materials has six bullish indictors, two of which are within the top decile. StarMine’s Smart Holdings model ranks stocks on their expected future increase, or decrease, in institutional ownership. The Smart Holdings model indicates that AMAT – with the highest possible score of 100 — has become increasingly attractive to institutional investors. Applied Materials will pop up as investors screen for companies with good growth and profitability characteristics.

Exhibit 2: Applied Materials Return on Net Operating Assets vs. Industry

Source: Eikon

Earnings sources

The quality of earnings has been shown repeatedly to be an important indicator; those companies whose earnings come from sustainable sources are likely to generate better financial results over the longer term. AMAT has a StarMine Earnings Quality (EQ) score of 93 on a scale of 1 to 100, with 100 representing the highest quality earnings. That puts the equipment maker firmly in the top decile of companies in North America, which is a bullish signal. A look into some of the model’s components helps to show why Applied scores so highly.

Applied is becoming more efficient and scores 75 out of 100 in operating efficiency, compared to the industry’s score of 62. Trailing four quarter operating profit margin for AMAT has steadily increased over the past year to 12.9% and surpassed both the semiconductors and semiconductor equipment industry median of 9.8% and information technology sector median of 9.8%. Gross margin has improved for seven consecutive quarters and was a major driver as trailing four quarter revenue increased 22.7% year over year compared to a 16.7% increase in cost of revenue.

Asset turnover measures how efficiently a company uses its assets to generate revenue, and our model measures both the absolute level and the rate of change in asset turnover. The trailing four quarter net operating asset turnover has increased 27% to 1.27 from its three year July 2013 low of 1.00. This has contributed to an increase in trailing four quarter average return on net operating assets to 16.5% from a three year low of 4.6% in July 2013.

Exhibit 3: Applied Materials: Cash Flow from Operations vs. Net Income

Source: Eikon

Flowing cash

Strong cash flows are another sign of good earnings quality. Over the past three quarters, cash flow from operations (CFO) has exceeded net income and steadily improved over the past three quarters. CFO has increased 60% year over year to $580 million and net income grew 79% to $301 million.

Based on the improvements to several of the earnings quality metrics, Applied Materials’ new management looks to be implementing effective strategies. Additionally, Tokyo Electron’s StarMine Earnings Quality score of 90 indicates that the merger should complement these efforts, and could potentially utilize some remaining tax inversion techniques to reduce tax rates.

Additionally, multiple strong StarMine Credit Risk model scores for both companies indicate that the combined balance sheet should remain in good condition. Heavy consolidation within the industry and complexities associated with new technology requirements are also strategically important. The merger may provide pricing and increased market share opportunities as equipment throughout the manufacturing process becomes increasingly reliant on compatibility with critical tools.