We rate AMAT Buy, High Risk (1H) with a price target of $22. As the semiconductor cycle forms a rolling top, we believe investors should focus on a metric that accurately captures cross-cycle earnings power. We thus focus on “normalized” earnings on the notion that the downturn will be more muted than any such downturn in recent memory. If we average peak rolling four quarter EPS of $1.25 (FQ4:06) and trough (fully taxed) rolling four-quarter EPS of $0.68 (FQ4:05), we arrive at a normalized full year EPS estimate of $0.97. We then note that the average 10-year historical S&P500 multiple (excluding the 1998-2000 Asian crisis/market bubble time period) is approximately 18.4x earnings. As semiconductor equipment capital spending is likely to continue growing in the high single digits % CAGR (or roughly 2x global GDP), we assign a 10% premium to the market for bellwether AMAT, and arrive at a multiple of about 20x earnings. Applying this 20.2x multiple to our $0.97 normalized earnings estimate, we arrive at a value of approximately $20. As this is based on cross-cycle normalized earnings, we consider this to be “fair value” for the stock. On a book value basis, the ten-year historical average is 4.7x. Applying the historical multiple to estimated book value per share at the end of CY2005 of $5.24 implies a price target of $25. As the semiconductor cycle forms a rolling top, we believe the most appropriate metric is one that takes into account a more muted cyclical downturn. However, as many investors are still concerned about the more traditional price to book method of valuing stocks, we do not wish to completely discount this. We thus assign a weighting of 75% to our normalized earnings method and 25% to book value. Therefore we arrive at a price target of $22, and we rate the stock Buy, High Risk (1H). Because this methodology and result should be somewhat consistent regardless of the point in the cycle, we would view this as a barometer of “fair value” whereby meaningful deviations above or below should serve as stock triggers. RISKS We rate AMAT High Risk, primarily due stock price volatility as well as earnings volatility. The following are key risk factors: 1. Our valuation methodology is based on the assumption that semiconductor capital equipment cycle will exhibit a shallower downturn than previous cycles. As fab utilization and capital equipment orders are closely linked to stock price, any material differences to our supply/demand model (e.g., demand drops suddenly, or supply increases more rapidly than we predict) may cause our valuation methodology to be inaccurate. 2. Applied has recently undergone changes in their senior management structure, installing a former Intel senior executive as CEO & President. While our limited exposure to customer reaction suggests a positive view to this change, we recognize the disruptions such changes in senior management can cause within a firm and the potential impact to operations and/or order flow. 3. Applied is currently undergoing an extensive cost restructuring program in an effort to align their infrastructure with their perception of future business levels. INVESTMENT THESIS We rate the shares of Applied Materials Buy/High Risk. With fab capacity utilization likely to stay tight relative to previous downturns, and backlog at equipment companies relatively low, our analysis suggests that the impending cyclical downturn will be relatively short and shallow, and that AMAT is unlikely to lose money at any point this cycle. With a breakeven level in the $1B range, orders would have to drop almost 60% from the likely peak in order for profitability to become a concern. We thus focus our valuation methodology around a normalized, ’cross-cycle’ earnings, which we believe is a better indicator of fair value. On that front, our modeled normalized EPS of ~$1.00 leads us to believe that fair value for AMAT is in the $20 range, which implies that there is significant upside to the stock from here. COMPANY DESCRIPTION Applied Materials (AMAT) is the leading supplier of semiconductor fabrication (fab) equipment to the global semiconductor industry. It is the market share leader in virtually every market it serves, with the notable exception of metrology and inspection, where KLATencor holds #1 share. AMAT supplied nearly 20% of all front-end wafer fabrication equipment to the approximately $17 billion market in 2003, as compared to 12% from nearest competitor Tokyo Electron, especially notable as AMAT does not participate in lithography, the single largest segment. The company has also expanded its efforts in service and spares, and is expected to continue expanding in the growing flat panel display (FPD) equipment market. We estimate that greater than 25% of revenue is derived from sources other than wafer fab equipment sales. 5 This report is made available in Australia to wholesale clients through Citigroup Global Markets Australia Pty Ltd.