Applied Materials (AMAT) is the world's largest semiconductor capital equipment company both in terms of value and sales. Semiconductor fabs are multibillion dollar factories where silicon chips that go into tablets and smartphones are made. These fabs house very specialized and complex equipment which are made by a handful of suppliers. Most of these companies are Japanese and US (ASML is an exception). Unlike other industries, the semiconductor capital equipment is a fairly stable industry with a massive moat. The Korean and Chinese companies have never managed to make inroads into the semiconductor capital equipment industry due to the high IP barriers. The growth in this industry has not been great, but it is safe from the competitive pressures unlike other sectors such as smartphones, tablets or PCs. KLAC (KLAC), Lam Research (LAM), AMAT and Tokyo Electron are the biggest players in the sector. They have a comfortable oligopoly with high margins. The industry has also been consolidating around the main players with Applied Materials buying Varian Semiconductor and Lam buying Novellus Systems.
We are positively biased towards Applied Materials because of its leading position in the "semicap" sector. The expenditure on the semi equipment is set to grow with the industry transitioning to smaller design nodes and shifting towards 450 mm wafers from 300 mm. Intel is already building out the first 10x nm node and plans to spend $2 billion on 450 mm wafers. Other companies such as Samsung and TSMC (TSM) will have to match Intel or get left behind. Intel (INTC) has already bought a big stake in one of the major semicap players ASML Holdings (ASML) to accelerate the technology advancement process.
Why we like AMAT
- Technology Advantage - Applied Materials has a tremendous technology advantage in a number of areas such as implant, PVD, CVD, etc. While the company competes with KLAC and LAM in a number of these fields, we do not think the company is in any big danger of losing significant market share. The company is perfectly capable of making equipment for smaller design nodes which would require increasing complexity. The company spends almost 15-20% of its revenues on R&D every year to keep its technological lead.
- Cyclical Trough - We think that Applied Materials is at the cyclical trough and its prospects should improve with increase in semi equipment spending. Management believes that the worst of the trough has passed and I believe them. The company's solar equipment revenues have fallen off a cliff (down 80%) and the only way to go is up. Display revenues should also go up in the 2nd half of 2013 as the industry recovers.
- Industry Consolidation - Competitive dynamics in the semiconductor industry are improving with the Tier 2 players like Varian and Novellus being gobbled up by the Tier 1 players. This will help the top 5 companies to maintain prices and improve margins. We do not see any new entrant coming into the semicap market anytime soon because of the high industry barriers.
- Decent Dividends - Applied Materials has kept on increasing dividends as the industry has matured. While the recent stock rally has decreased the yield from ~3% to 2.65% now, it is still a decent yield for a technology company. AMAT also operates in a less competitive space than other companies so it makes their yield much safer. Dividends have grown by 500% from 6 cents in 2005 to 34 cents in 2012.
- Strong free cash flows - Applied Materials manages to earn an average of ~$1.5 billion in free cash flows every year as the capex requirements of the business are quite low. Though earnings in the last year were affected due to big restructuring charges, FCF was still quite strong.
Applied Material Risks
- Solar Market Problems - The whole solar energy market has been hurt hard by the overcapacity in solar panels. Applied Materials has become the No.1 supplier of equipment to solar companies, through acquisitions. However, all has not been rosy for AMAT, which was forced to abandon its amorphous silicon thin film equipment line in 2009. The company has also sharply reduced spending on crystalline solar panel equipment after the whole market crashed. Pure play solar equipment companies like GTAT and Meyer Burgher are trying to survive this tough period.
- Declining PC market - The PC market is showing declining revenues and volumes, as tablets cannibalize the laptop market. However, the growth of smartphones and tablets has managed to offset some of that growth decline. AMAT has been hurt from a decline in the memory segment revenues apart from slowing of the logic revenues.
- Slow growth - Applied Material's revenue in 2012 was only 10% up from its 2004 level, despite the company having made major inroads into the Display and Solar equipment markets. However, the thing to remember is that the company plays in a cyclical industry which is going through a trough right now. Its revenues in 2011 were $10.5 billion. The company expects WFE equipment spending to range between -10% - 0% growth in 2013. Given Intel's capex announcement, I think that it will be on the higher end. However, there are global economic slowdown risks which also have to be taken into account.
Stock performance has not been good
AMAT stock has been rising sharply in the second half of 2012 and 2013. The company is currently trading very near to its 52 week high of ~$14. The company has underperformed the broader market losing ~27% in the last 5 years, compared to the ~37% NADAQ return. The company has also underperformed its peers such as KLAC and LAM. Semi companies such as Intel (+5%), Texas Instruments (TXN) (+11%) and Qualcomm (+55%) have done much better than Applied Materials.
Applied Materials is trading in line with the industry average after the sharp rally in recent days. The company's forward P/E of 14.5 is roughly equal to that of the broader market. The P/B and P/S at 2.3 and 2.0, are at a ~20% discount to the industry. The company's debt equity ratio at 0.3 is exactly equal to the industry average.
Applied Materials is a good stock to own in an industry which is slowly consolidating around the top 5 companies. The complexity and technology of making equipment for the semiconductor companies ensures a big moat around the company. It is one of the few industries where Asian competitors have not managed to get any sort of penetration. Applied Materials has passed through the worst of the cyclical trough in the three industries it supplies equipment to. The market has already recognized the potential with the share going up by almost ~40% in the last few months. I would look to buy this stock on dips, as the company benefits from the semiconductor industry's move to smaller design nodes and 450 mm wafers.