5 Reasons Why This Chip Stock is Undervalued

Despite a fairly bleak quarterly report from Cisco Systems (Nasdaq: CSCO) on Thursday, investors should realize that troubles for Cisco don’t mean trouble for the whole sector. In fact, the tech sector has shaken off the gloom and doom of this summer, with the Nasdaq surging +20% since late August.

The rebound in the Nasdaq comes from an increasing sense that tech spending will rise steadily higher in 2011 — which means more profits for tech firms. And when tech firms are feeling flush, they go out and invest in new equipment. The prime beneficiary: Applied Materials (Nasdaq: AMAT), the world’s largest producer of chip-making equipment. That’s reason enough to be bullish on shares.

Here are five more reasons:

1. Rich and getting richer. Applied Materials has $2.3 billion in cash, and there’s more to come. Citigroup figures the company will generate nearly $2 billion more in operating cash flow in the fiscal year that began this month. Applied Materials continues to buy back stock at a prodigious clip, yet cash could still approach $3.5 billion ($2.50 a share) by the end of the current fiscal year.

2. Cheap and getting cheaper. If you back out that cash balance, Applied Materials trades for around 10 times trailing profits, and around seven times projected fiscal (October) 2011 earnings. Looked at another way, shares trade for just 5.5 times projected 2011 EBITDA.

3. An imminent resolution to the Samsung ordeal. Applied Materials appears close to settling an embarrassing lawsuit with Samsung. Some of the company’s employees in Korea apparently sold Samsung’s secrets to a rival, leading Samsung to cut off its business and sue. Analysts think Applied Materials is about to cut Samsung a $200 million check to resolve the mess, at which time analyst think it will place some new orders with Applied Materials that had been on hold. Shares have been under pressure on fears that the issue would linger on and perhaps prove even more costly. A settlement could help fuel a relief rally.

4. Trends are rising, not sinking. Applied Materials operates in a highly cyclical industry. Company sales plunged -38% in fiscal 2009 and likely shot up more than +80% in fiscal 2010. (Full-year results will be out next week). Many analysts think semiconductor capital equipment sales will slump anew next year, although Applied Materials’ market positioning should yield a +10% gain in revenue.

But a growing minority of analysts think the industry is actually set to fare quite well next year, and that Applied Materials can grow closer to +20%. (Consensus estimates range from 0% growth to +35% growth). The rising bullishness stems from an arms race among chip foundries. These are the folks that make chips on behalf of other tech companies that design and sell semiconductors without actually making them. GlobalFoundries, a new player in the foundry industry has been aggressively ordering new equipment, leading rivals to make sure they also own state-of-the-art gear. Goldman Sachs believes that GlobalFoundries “could invest $15-20 billion of capex cumulatively from 2010 to 2015.” And it thinks other foundries such as Taiwan Semiconductor (NYSE: TSM) will follow suit. Applied Materials is likely to focus on this topic on next week’s conference call.

5. Solar goes from headwind to tailwind. The solar market held great appeal to Applied Materials, as many manufacturing processes for solar wafers are quite similar to the processes needed to make semiconductors. But the company got too greedy, also entering the commercial market by selling solar panels. That move dampened profit margins and soured investors. Applied Materials got wise this summer and tightened its solar focus to proven, profitable segments. As a result, year-over-year financial comparisons are likely to start looking better and better, and the whole solar operation should morph from a money loser in fiscal 2010 to a money maker in 2011.

Action to Take –> This is not a call for you to buy shares ahead of next week’s conference call. Seasonal gyrations mean that October quarterly results may come in above or below forecasts. Instead, this is a call on 2011, when a series of real and imagined headwinds become tailwinds. This industry leader, with oodles of cash, still ensconced in a favorable phase of the cycle, and an ultra-low price-to-earnings (P/E) ratio, should move back into favor in coming quarters.