Applied Pessimism

Pity Applied Materials (NASDAQ:AMAT). Despite reporting decent earnings on Tuesday, the world's dominant producer of semiconductor-manufacturing equipment has seen its shares slip 4%, thanks to an earnings conference call that apparently underwhelmed investors.

Here's the bad news, in a nutshell: Fiscal Q2 2007 sales grew 13%, but charges related to restructuring efforts, and to its recent purchase of the software division of Brooks Automation (NASDAQ:BRKS), kept profits flat year over year. (A reduced share count still allowed profits per share to rise 12%.) Moreover, the company advised that new orders rose only 6% in the quarter -- promising slower sales growth going forward. And in the post-earnings conference call, Applied warned that new orders in the current third fiscal quarter looked likely to fall 10%-15% sequentially, worsening investors' fear of slowing sales.

But are all of those factors reason enough to apply so much pessimism to the stock? I think so. Examining the company's longer-term, year-to-date performance, we see that Applied has done well in improving the rate at which it extracts profits from its sales (mitigating the profit risk of a sales slowdown.) Year to date, the firm has shown year-over-year improvement as follows:

• Sales are up 17%.
• Gross margin is down 10 basis points to 45.8%.
• Operating margin soared 650 basis points to 23.7%.
• Net margin leapt 350 basis points to 17%.

Applied currently boasts better operating margin than that of rivals KLA-Tencor (NASDAQ:KLAC) or Tokyo Electron, though it lags that of Lam Research (NASDAQ:LRCX).

But if sales in the firm's biggest segment -- silicon chip-manufacturing equipment -- slide, Applied's margins should suffer disproportionately. At last report, "silicon" segment sales weren't just Applied's biggest business, but its most profitable by far. Boasting a 34.9% operating margin, Applied makes nearly 1,000 basis points more operating profit on a dollar of silicon-segment sales than it does in its next-most-profitable segment, fab solutions. If management is right, and the sales slowdown hits DRAM manufacturing equipment sales particularly hard, it could quickly reverse the margin improvements we see above.

One more thing...
To the above thesis, I'd also point out that although Applied didn't do its investors the courtesy of including a cash flow statement in its earnings release, it looks to me like we could see a deterioration in free cash flow generation once that document appears in the 10-Q filing. Year over year, inventories grew 36% in the second quarter, and 42% for the first half of the fiscal year. Both numbers exceed Applied's 17% sales growth, suggesting to this Fool that free cash isn't flowing as freely this year as last.

We've chipped in with further Foolishness:

• Applied Materials Serves Itself
• Applied Materials Sees the Light
• Spending Money at Applied Materials: Fool by Numbers

Fool contributor Rich Smith does not own shares of any company named above.