The Day Ahead: Applied Materials makes bullish case for chips

Memo to those analysts worried about a semiconductor slowdown and potential supply glut: Applied Materials thinks you're way too early with the pessimism.

When Applied Materials, the leading supplier of semiconductor equipment, speaks, Wall Street listens. And the company is as bullish as it has ever been.

Applied Materials topped estimates in its third quarter Wednesday with earnings of $604m, or 70 cents per share. First Call's survey of 28 analysts predicted a profit of 68 cents per share for the quarter ended 30 July. Sales jumped to $2.73bn, 25 percent higher than a year ago. The company had a backlog of $3.69bn at the end of July, compared to $3.18bn at the end of April.

Although those results were enough to cheer investors, Applied Materials' outlook was the focus. Chief financial officer Joseph Bronson said the company's new orders in the fourth quarter will top $3.5bn with sales in the $2.85bn to $2.9bn range. Fourth quarter earnings will be in line with current consensus estimates of 75 cents a share.

"There has never been a period of time when this industry has had such growth rates," said Bronson, who added that he expects that "the current industry up cycle will continue".

David Wang, Applied Materials' resident industry guru, said the industry is showing strong balance and there's nothing that would derail the chip sector in the next year. Applied Materials' customers, who happen to be the biggest players in the chip world, are optimistic.

Officials cited six main reasons for their bullishness:

Although Applied Materials' outlook is nice, bearish analysts will remain unconvinced because each of the six reasons above can be shot down. Applied Materials projected a year's worth of demand. The big question: how much of this upside is already priced in?

In a report earlier this week, USB Piper Jaffray analyst Ashok Kumar became the latest analyst to say the chip cycle has peaked. Salomon Brothers analyst Jonathan Joseph was the first to raise red flags.

Based on fundamental and technical evidence, Kumar said PC growth rates are slowing, cellular handset shipments have peaked and oversupply is on the way. Peaks and valleys are nothing new, but the real trick is calling booms and busts ahead of time.

On PC growth rates, Kumar expects shipments to peak in the September quarter. Flash memory, which is used in wireless devices, is expected to overshoot supply in the summer of 2001.

How does this affect Applied Materials? When AMD, Intel and wireless chip customers get squeezed, they'll stop buying manufacturing equipment.

Now there are plenty of analysts to dispute Kumar and company, but the legions of worrywarts are growing. Wit SoundView analyst Michael O'Brien said the chip boom still has some legs and added that Applied Materials will benefit.

Kumar's view: No one knows for sure when chip stocks will unravel, but a little profit taking never hurts. "Wealth accumulation is not only about making money, it is also about keeping it," he wrote. "We believe there are an abundance of reasons for keeping your powder dry and sitting on the sidelines."

Applied Materials chairman James Morgan acknowledged that the company's forecasts include only "the things we know about".

In its recent earnings report, Nokia signalled that growth was off slightly. That outlook sparked a host of worries about the wireless sector, which is driving chip sales and capital spending.

Nokia's report lends some support to Salomon analysts Joseph's view, which projected a slowdown in six to nine months. Applied Materials customers' are bullish now, but three quarters from now things could change. Big plant spending has been derailed before.

If Kumar and Joseph are even partly right, we could see the introduction of enough unknowns to temper Applied Materials' outlook.

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