Don't Get Hooked on Applied Materials

Long ago on a misty Mediterranean shore, there lived a mythical band that subsisted on the narcotic leaf of the Lotus flower. Today in America, descendants of the Lotus Eaters instead rob corner drugstores of OxyContin. Or, if they're capitalists, they trade dollars on NASDAQ for semiconductor stocks.

The rush of pleasure promised by chip stocks can be so intense that it's understandable why some investors, after so recently having endured the agony of withdrawal, are now back to craving ecstasy. As an example of semiconductor investing's two sides, there's no better stock than Applied Materials. The leading maker of big, expensive machines that create tiny, precious microchips, Applied Materials logged a total return through the 1990s of better than 7,000%. Crashing in the new millennium, it soon lost four-fifths of its market value. Lately, Applied Materials is flying again, hovering under $20, up from $10.26 a year ago.

RISING OR FALLING? The question for investors today is whether Applied Materials is just warming up for another towering vault or has swiftly outrun its foreseeable prospects. There can be no question of the Santa Clara (Calif.) company's prowess. Its balance sheet, with cash and short-term securities enough to pay its debts almost eight times over, is pristine. Free cash flow, more than $520 million in the past 12 months on sales of $4.7 billion, is growing again. And Applied Materials has invested heavily to exploit the chipmakers' continuing switch to production of larger, 300-millimeter wafers. Just the same, if anyone expects me to buy the stock, please first pass the OxyContin.

The reasons begin with two stock market telltales that, while hardly conclusive, should not be ignored. First is the untethered enthusiasm surrounding chip stocks generally. The Philadelphia Semiconductor Index, anticipating a cyclical upturn for which there is yet scant evidence in the monthly reports of fresh orders, is up no less than 55% this year. Second, this warm atmosphere has lured NPTest, a semiconductor-equipment company recently sold by Schlumberger (SLB) to refile papers on Sept. 10 for an initial public offering. The deal had originally been planned for 2002 but was then delayed and ultimately canceled. Its revival signals that the market in chip stocks is once more welcoming enough that knowledgeable sellers are selling.

Most specifically worrisome about Applied Materials is Wall Street's amnesiac insistence on focusing on the company's recent pro forma results. Applied Materials doesn't use the discredited term "pro forma." It instead characterizes its profit after a variety of special charges as "ongoing basis" results. In any case, there is a striking difference between "ongoing basis" and actual: Through three quarters this fiscal year, instead of the widely disseminated "ongoing basis" profit of 8 cents a share, Applied Materials actually lost 10 cents.

What's wrong with using "ongoing basis" results if they offer a clearer look at the company's future? Nothing, except they carry the silent assumption that next year will suffer no more extraordinary write-offs. The consensus estimate of analysts for fiscal 2004 earnings is 46 cents a share. That would be quite a leap from the 13 cents in "ongoing basis" earnings analysts see for fiscal 2003, ending in October. Yet from this year's actual loss, 46 cents a share next year would prove an even bigger jump -- a feat so incredible few bulls dare to dwell on it.

For kicks, let's say the chip business next year goes gangbusters. Let's assume that Applied Materials delivers the 60 cents a share in profit that is today's highest estimate on Wall Street. That means if you buy the stock today at $20, you will have paid 33 times the coming year's profit. Back in October, 1998, investors in Applied Materials paid 19 times the earnings that eventually came in during the next fiscal year. The stock in that time went up 159%. A year later, when the stock was poised to make a similar leap, investors still paid only 19 times the coming year's profit. Will someone please call the Betty Ford Center? By Robert Barker

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