Yesterday, I bought 2 call options at strike $5 expiring in Jan 2014 for $5.55 each and sold 1 put option with strike $10 expiring in Jan 2014 for $1.68. If you do not understand options, have a look at my previous article on writing puts. What you need to know is that both these strategies are going to be profitable for me if the stock goes up.
Given that I have decided to concentrate my portfolio, I am only adding high quality companies. Specifically, the company should satisfy all of the following requirements
- A business with wide moat and stable operating environment,
- easy enough to understand *for me*,
- with a very good balance sheet especially if it is in a cyclical industry,
- run by able and honest managers, and
- priced at a large discount to intrinsic value.
All and let me repeat, all of these conditions must be met before I will invest in the business. This is imperative because I like to add to my holdings when after buying they keep dropping and offering me better and better value. I have been scared out of adding to my positions after a big drop because one of these conditions were not met. So, I have decided to be on the safe side. Given that the stock market is huge and at any given point there are numerous options to invest in, there is no reason to settle for something less for your money. If you do not feel comfortable, do not invest !
I will look at Applied Materials (AMAT) in this light and see if it makes good on everything I promised above.
One of the most important criteria is the business the company is in. For example, investing in Groupon is inherently risky from this perspective. The company has no barrier to entry (anyone can copy the website and procure deals from local businesses if they undercut Groupon on the margins) and the underlying business model is very fragile. There is no customer loyalty to speak of and hence it leads to cutthroat competition and eventually low margins for everyone.
Another important criteria is the capital expenditure of the business. Groupon has a very low cap-ex. To expand its business to a new country, it only needs to copy its website and hire a small marketing team which will approach local businesses for the deals. On the other hand, France Telecom (FTE) is a business with high cap-ex. It not only needs to modernize the old infrastructure (wires and equipment) to keep pace with the ever changing landscape of mobile and wired technologies, it also needs to spend large sums of money to expand into new markets.
Let us look at the business of AMAT along these two criterions.
AMAT operates in the following segments.
- Silicon Systems Group (SSG): provides tools and equipments for various steps of semiconductor manufacturing process
- Applied Global Services (AGS): produces spares and provides replacement services for old customers.
- Display Segment: Sells products for manufacturing LCDs for TVs and PCs.
- Energy and Environmental Solutions (EESS): Sells equipment for fabricating solar PV products, coating systems and energy efficient glass manufacturing equipment.
Simply speaking AMAT is in the business of making machines that build semiconductors.
Semiconductors are the backbone of the modern civilization. They are found in computers, phones, iPads, televisions, and numerous other electronic equipments. As we know, there is an intense competition between Hewlett-Packard, Apple, Nokia, Research in Motion and also Intel, AMD, Nvidia in segments of the technological pie. The competition is sometimes brutal and has driven some companies on the brink of obsoletion (example Nokia, Research in Motion). Other companies have suffered a large threat to their business by upstarts (Cisco) or due to management missteps (Hewlett-Packard). In short, the tech sector offers a very volatile and ever-changing landscape. Applied Materials on the other hand stands in the back of all this fight. It does not make a product which directly goes to the consumer but it makes products for the companies who make products for their customers. It does not care who wins the smartphone fight between Apple, Nokia and Research in Motion. As long as smartphones are made, the company which makes them will need equipments to put together the chips that enable the smartphone to work. All these chips will need AMATs machines to put them together. AMAT is the largest supplier of the equipments to this industry, a position which it has held since 1992.
The manufacturing process for the thin film transistor (TFT) liquid crystal display (LCD) used in notebook computers, televisions, and desktop monitors is also quite similar to the integrated circuits for semiconductors. AMAT is the number one equipment supplier to this industry and has been a leader since 1993. Nearly every display in the world today was made by using AMATs’ equipment.
Solar energy is the dark horse in AMATs portfolio of products. They are also #1 provider of solar equipment i.e., wafer and cell producers manufacturing systems.
AMAT competes with Novellous Systems (NVLS), KLA-Tencor (KLAC) and Lam Research (LRCX) in different segments of the market.
I hope that with a bit of understanding of the business which I talked about just now, I have convinced you that AMAT has a relatively stable business compared to the likes of Nokia, Cisco, Hewlett-Packard and Research in Motion. The landscape in the equipment industry is relatively less crowded and AMAT has managed to keep its leadership position since 1992 (almost 20 years now).
Let us come to the second criteria for the business, which was Capital Expenditure. This is not one of the businesses for which we can easily say what the cap-ex will be. So, we pull up the figures from the last 10 years from Vuru.co.
We see that the income has increased quite dramatically and the capital expenditure has also come down quite a bit as a percent of net income. This is a good sign. So even though the business does not seem to be one with very low cap-ex (like See’s candy), it is not very capital intensive either.
The balance sheet
One of the most important criteria. If you want to buy the stock when it is selling for say 50% less than what you bought it for a few months back, you want to be sure that the company has enough cash to survive the downturn the market seems to be scared about. And don’t think this does not happen a lot. It happens to even the best of us. Look at where Donald Yacktman bought Hewlett-Packard (hint: around $28 and it is selling for $19).
So, a strong balance sheet is going to be one less thing to worry about, if the management missteps or there is a downturn in the business cycle.
|Item in $m||Period ended 29.04.2012|
|Cash and short term investments||1,761|
|Total current assets||6,330|
|Total current liability||2,666|
We see that AMAT has a very strong balance sheet. It has enough cash on hand to pay all its debt.
This is not an anomaly as AMAT has maintained a very good balance sheet even historically.
The quality of the management of AMAT is one of the best. The company is very shareholder friendly and does not reward its management by outrageous sums of money/stock options.
The CEO of the company is Michael Splinter who has been CEO since 2003. Prior to joining AMAT Splinter was an executive at Intel where he worked for nearly 20 years including executive VP and director of sales and marketing. During his tenure AMAT has doubled its revenue and have stabilized its FCF (see under valuation).
The company’s compensation plan is quite good. AMAT tries to mimic the performance of the company when designing the compensation for the management.
If we compare the net income and net sales to the total compensation of the CEO then the graph is quite similar.
There is no executive retirement plan, no change of control arrangements (as opposed to FCX, see Are you kidding me FCX ?) and no executive health plan. The burn rate of the equity because of options award was a meager 0.85% i.e., for every 100 shares the company diluted 0.85 shares on stock awards. The total executive compensation was $28.52 million in 2011 which I am quite happy about.
AMAT has also been buying back a lot of shares. The share count has gone from 1.7b in 2002 to 1.28b in the most recent quarter. On Mar 5, 2012 it announced to expand its share buyback to $3b by adding another $2b on top of the leftover $1b from a previous buyback announcement.
The company has market cap of $13.6 billion. It has $1.76 billion in cash and $1.9 billion in debt. The Enterprise value is hence less than $14b. Here are the FCF figures from the vuru website.
When the new CEO joined in (circa 2004) the average FCF is $1.44 billion. Given this as a base and with a 10% hurdle rate the market expects the FCF to grow at -1.31%.
The company is also selling at the low end of its P/E (current 10.3) and yields 3.2%.
It is difficult to say what the fair value of the company is. It depends on what the market is willing to pay in terms of P/E and P/S multiples. Given the wide moat, an able and honest management, and a relatively stable business with leadership position in most of its product segments, a P/FCF of 12 is a reasonable sum to pay. This pegs the shares to $14.67, which is a 38% upside from the current price of $10.5.
The business of AMAT is such that you can expect a lot of volatility. The equipment sales are unpredictable and depend when say Intel needs to set up a new plant or upgrade an old one. This means that the company depends a lot on the vagaries of the customers and the economy. People with short term profit in mind should stay away from the business as the lumpiness of the performance leads itself to a lot of speculative based trading.
Many of the well known companies like Intel, Apple are becoming “fabless”, what it means is that they outsource the production of chips to a different company. For example Taiwan Semiconductor is one such company. AMAT will hence need to sell the equipment to Taiwan Semiconductor and not Apple/Intel. AMAT receives nearly 22% of its revenue from Taiwan. Such a concentration of revenue to one small country leads itself to geopolitical risk. An instability in Taiwan (political or natural) will have major adverse effects on AMAT.