Why Analysts Are Less Positive After Applied Materials Killed Its Merger

For some background: Applied Materials and Tokyo Electron announced early Monday morning that they have agreed to terminate their merger. In accordance with the agreement, no termination fees will be payable by either party. The merger was originally announced in September 2013.

Basically, this decision came after the U.S. Department of Justice advised the parties that the coordinated remedy proposal submitted to all regulators would be insufficient to replace the competition lost from the merger. Based on the Justice Department’s position, Applied Materials and Tokyo Electron determined that there is no realistic prospect for the completion of the merger.

At the same time as the announcement of the merger termination, Applied Materials announced a $3 billion share repurchase program that will take place over the next three years.

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S&P Capital IQ commented on the termination in its call:

We cut our 12-month target price by $4 to $22, on P/E near peers. AMAT and Tokyo Electron have agreed to terminate their pending merger. The parties stated the transaction was no longer plausible after the U.S. DoJ advised both that a proposal submitted to all regulators would not be sufficient to replace the competition lost from the merger. AMAT also approves a $3B share repurchase program over the next 3 years. Following recent capital spending budget cuts from key customers and the termination of the Tokyo Electron merger, we see future earnings leverage as less attractive.

In its preview of the merger, Credit Suisse highlighted that this would be the main hurdle, although the result was disappointing. However, the stock is still inexpensive on valuations and has strong fundamentals.

According to Credit Suisse:

We estimate Applied Materials can earn $1.55 in CY16 on Standalone basis (without benefit of buybacks). Over next six months, investor focus will move to 2016 estimates – Applied Materials is trading at 12x versus S&P at > 15x. (ii) Announced buyback represents 12% of Market Cap. We estimate that announced buyback can add $0.18 per year in earnings, albeit full benefit will likely be realized by FY17. We would further note that company still has potential to pursue additional $4.5 billion (additional $0.28 per year EPS) of buybacks should it increase debt to EBITDA to 3x.

As a result, Credit Suisse lowered its price target to $25 from $30, but with an Outperform rating.

Merrill Lynch estimates that Applied Materials could earn $1.52 in the 2016 calendar year at around 22% operating margins, since it expects operational efficiency to flow through in calendar year 2017. Peers are trading at a range of 13 to 23 times 206E EPS. Based on mid-range of the multiple, the firm arrived at a $26 price objective.

The brokerage firm detailed in its report:

The lack of TEL could make Applied Materials more palatable as a key, but not dominant, supplier by its customers. This could play well to future share gain opportunities since customers might view Applied Materials (only) as not having a huge footprint in their fabs. We view the margin improvement as a rational possibility since the management has been focused on the merger over the last 19 months and operational decisions would be different for Applied Materials stand-alone compared to Applied Materials + TEL.. A normalized earnings power of $1.70 is achievable, in our opinion.

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Finally, other analysts also weighed in on the stock:

• Goldman Sachs initiated coverage as a Buy rating with a $24 price target.
• Stifel kept its Buy rating but moved its price target to $24 from $29.
• Nomura downgraded Applied Materials to Neutral from Buy.

Shares of Applied Materials were up 1.6% at $20.29 Tuesday morning, in a 52-week trading range of $18.48 to $25.71. The stock has a consensus analyst price target of $26.39.