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THE DAY AHEAD: Applied Materials&#039&#039 outlook creates tug-of-war

COMMENTARY -- Investors face quite a conundrum over Applied Materials' earnings and outlook. Using the "could have been worse" logic, Applied impressed with better-than-expected first-quarter earnings, but then delivered a depressing outlook.

Get ready for the tug-of-war.

Is Applied Materials (Nasdaq: AMAT) a company that ...

    A. Sees its business fundamentals deteriorating? Investors should avoid the stock until things smooth out, possibly in its fiscal third quarter.

    B. Will be able to grab market share in a downturn, making it a good buy right now?

    C. Will make a nice trade right now, but a bad investment?

If you answered all of the above, you're probably right--not to mention just as conflicted as the rest of Wall Street.

Applied Materials is far and away the leading chip equipment maker. It's the Intel (Nasdaq: INTC) of chip equipment, but may even have a better market position in its sector. Yes, Applied Materials had already warned for this quarter, but it exceeded lower expectations. Not bad considering the well-publicized slowdown in the chip sector.

The company reported fiscal first-quarter earnings excluding charges of 66 cents a share on sales of $2.73 billion. Both figures handily topped reduced estimates. Orders also came in at expectations of $2.43 billion.

But then there's the outlook. CFO Joe Bronson said business in January was softer than the company had projected because customers delayed rollouts of new equipment. Customers with strong business prospects are putting off capital expenditures, weak customers are reevaluating or deferring spending while others are merely taking a wait-and-see approach as the economy goes soft.

With that environment, it's no surprise that the company cut its outlook for the second quarter. Simply put, Applied Materials' April quarter is going to be ugly. Bronson projected second-quarter earnings of 32 cents a share to 37 cents a share, well short of First Call's consensus estimate of 49 cents a share. Revenue for the quarter will be about $1.9 billion to $2 billion, well below estimates of $2.4 billion.

CEO James Morgan noted the company is in the best financial shape ever, but said Applied Materials will be cost cutting--delaying raises and eliminating temporary positions. Morgan said the capacity in semiconductor plants will decrease from maximum production to about 70 percent or lower by the end of the quarter.

It's safe to say Applied is bracing for a severe downturn.

And why not? Morgan thinks the two consensus views of the economy are a bunch of bunk. The first view is that the economy will rebound in the second half. The second is that the downturn will last all year. "We don't subscribe to either," said Morgan. "No one can predict the future accurately."

Morgan, known as a straight shooter, was just being honest. He's managing the company so it can handle anything. Analysts agree that Applied Materials has "excellent ability to manage the downturn."

Deutsche Bank analyst Tim Arcuri is recommending a "trading strategy vs. investment strategy" over the next few months as the profit warnings keep coming and long-term investors duke it out with those betting that Applied Materials shares will fall.

"Results provide little support for second-half recovery in fundamentals," he said, noting that Applied's cost cutting indicates the company is "preparing for a deeper--and longer--downturn than current stock valuations may suggest."

Arcuri said the only good news is that Applied Materials may be near the bottom. "All is clearly not lost here as we continue to be huge believers in the upside opportunities for this group over the next 18 months," said Arcuri. The big question is why would you buy into Applied Materials now when you can wait for signs of a recovery?

Lehman Brothers analyst Edward White was more upbeat. White said even if the tech sector doesn't rebound until 2002, chip makers will have to buy equipment in the second half of 2001 to get ready for strong demand.

White argued that Applied Materials' forecasts assume there is no rebound in 2001. However, a Lehman survey of leading chip makers suggests a second-half comeback. "We are firmly of the view that semiconductor equipment stocks are best bought when the fundamental news is bad. This is such a situation," said White.

All you need is a strong stomach and a crystal ball.TDAIN


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