"The most important company nobody knows about."
These are President Barack Obama's words when he visited Applied Materials Inc. (AMAT). This value creator is a superior competitive intelligence minded organization that is well positioned to benefit from the surge in smart phones, tablet computers, and solar equipment that will accompany the expected coming worldwide economic rebound. Alpha seeking investors should know more about Applied Materials. To this end, we present a thorough analysis based on the principles of financial economics and the economic strategy that will allow us to obtain rigorous results on the sustainability of Applied Materials competitive position and its ability to produce positive excess returns.
AMAT with revenues of $8.7 billion and investment in R&D of $1.2 billion in fiscal year 2012 is the world's largest supplier of manufacturing equipment and services for the semiconductor, flat-panel display and solar industries. About 75% of its revenue comes from Asia, up from about 50% a decade ago. It has a significant presence throughout Asia in China, Taiwan, Singapore, India, Japan and South Korea, and is continuing to grow its footprint in the region as we have been able to witness by visiting most of these countries recently. The semiconductor industry can expect to see continued growth in Asia and, by extension, so can semiconductor equipment manufacturers. Asia has become the most important market for companies in this space.
Specifically, the company's activities consist of developing, manufacturing, marketing and servicing semiconductor wafer fabrication equipment and related spare parts for the worldwide semiconductor industry. Customers for these products include semiconductor wafer manufacturers and semiconductor integrated circuit manufacturers, who either use the integrated circuits they manufacture in their own products or sell them to other companies. These integrated circuits are the key components in most advanced electronic products such as computers, telecommunications devices, automotive engine management systems and electronic games.
Creating value takes more than acceptance of value maximization as the organizational objective. All companies say that, but they are often just words. The choice of value maximization as the corporate objective must be complemented by a corporate vision, strategy and tactics that unite participants in the organization in its struggle for dominance in its competitive arena. How does an investor determine if a company is creating value or not? By referring to the concept of market value added.
Market value added is the spread between a company's overall market value, given its share price, and the capital invested in its business to produce this value. It is the difference between the sum of cash that investors have put into or left in the business as its capital and the present value of the cash they could expect to take out of it, if only by selling their shares. As such, it represents how much wealth the firm has created. As shown in the following table, AMAT is a real value creator with a market value added of around 40%. The behavior over time of the market value added should give assurance that the alpha we expect to obtain in investing in a particular stock will persist.
Market Value Added (trailing 12 months) (in millions$)
Total Market Value
Market Value Added
Companies that are leaders in value creation, like AMAT, bring a different mindset and take a different approach to strategy development. They strive not just to be different from their competitors (which is necessary yet insufficient), but also to be both different from and more profitable than their competitors. They realize that others will seek to copy their success; therefore, they strive to develop capabilities and strategic assets that are hard to match. Creating such distinctive strategies is a difficult challenge, and only a few companies in any given industry are likely to be successful at implementing and sustaining them. This is the case of Applied Materials. The fact that AMAT has engineers in nearly every chip-manufacturing facility in the world has allowed it to develop close relationships with customers, giving it insight into current and future customer technology needs. This is a real competitive advantage, a formidable competitive intelligence gathering strategy that competitors cannot copy overnight. It is not surprising then that AMAT is the chip equipment industry's standard bearer.
Where does the market value added come from and how do you know that the company will continue to add market value in the future? Simply by looking at the performance spreads over time.
Sustainable Competitive Advantages
One of the keys to finding superior long-term investments is to buy companies that will be able to stay one step ahead of their competitors. Companies that have generated returns on their capital higher than their cost of capital for many years of operation usually have a competitive advantage, especially if their returns on capital have also increased over time. This line of reasoning is fundamental. In other words, having an unexpected or a temporary competitive advantage is not enough for a business to be able to declare that it has a competitive advantage.
Simply put, we cannot expect to obtain abnormal returns (alpha) as an investor if the business we invest in does not have a sustainable competitive advantage. We compute sustainable competitive advantage as the difference (the performance spread) between the return on capital and the cost of capital (correctly measured, that is after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions). Everything else being equal, the higher the performance spread, the bigger the competitive advantage.
Substantial competition exists in all areas of Applied's business. Competitors range from small companies that compete with a single product and/or in a single region, to global, diversified companies with a range of products. To give an idea of the competitive landscape, we present in the table that follows the performance spreads over time of AMAT and two of its competitors: KLA-Tencor Corporation (KLAC) and Lam Research (LRCX). We must keep in mind that AMAT is about two times the size of these competitors. Indeed, the market capitalization of these three firms, AMAT, KLAC, and LRCX are respectively of $18.66B, $9.74B, and $8.02B.
The examination of the data in the following table shows that AMAT has more stable performance spreads than the competition, revealing its strong competitive position. Although at a lower level, the other two competitors also enjoy clear competitive advantages.
The data must be placed in perspective with the worldwide economic instability that followed the financial crisis of 2008. For example, the gross fixed capital formation over the period 2008-10 fell on average by 4.2% per year for the OECD as a whole. This entrenchment in investments occurred around the world and persisted until recently. This is why the "everything else being equal", that precedes the economic statement that "the higher the performance spread, the bigger the competitive advantage" should not be forgotten in its application. This caveat is all the more significant that the analyzed companies are in the semiconductor equipment and materials industry group.
In times of international economic crisis, being able to produce positive performance spreads or, negative performance spreads that do not stray too far from the level of 0% (that represents a competitive equilibrium), shows that alpha seeking opportunities await only a worldwide economic return to normal.
Performance Spread [PS] (Trailing 36 months)
Applied Materials Inc.
Lam Research Corp.
As a long term value investor, we know that, over time, market value and intrinsic value converge. A company with a positive performance spread (PS), that is a return on its capital greater than its cost of capital, a necessary condition for market value creation, will see it decrease to zero, if it is not able to embark on a new strategic value increasing trajectory. That is not the case for Applied Materials for the reasons explained previously. Also, in the particular context of the semiconductor equipment and materials industry, we need to incorporate the expectations regarding future gross fixed capital formation.
Equipped with the above information on performance spreads and the fact that we are in the presence of competitors that are also value creators, it follows that a breakthrough in value creation is not expected without a worldwide economic rebound.
In this competitive landscape, we have estimated the implied capital market expectations with regard to the expected future return on capital (see the market expectations column in the table below) for each corporation. For KLA-Tencor and Lam Research they are in perfect harmony with the return on capital that could be expected for these firms with a return of economic prosperity based on their performance over the period analyzed (2009-2013). It follows that their intrinsic values are equal to their market price. For Applied materials, the implied capital market expectations with regard to its expected future return on capital is 15.6%. However, it appears to us that the market is too pessimistic about its future and a better estimate of the future return on capital should better in line with the results obtained in the year 2011. Furthermore, a more detailed examination of the data (not presented here) also reveals that, on a trailing 12 months, these three competitors have obtained their best performance spreads (and return on capital) in the same month of June/July 2011. We use these returns on capital as a benchmark to guide our estimates of intrinsic values.
This line of reasoning gives an intrinsic value of $20 for AMAT. Here is an alpha opportunity.
A superficial knowledge of how prices are established in the capital markets and an over confidence on a point estimate of the intrinsic value would cause some analysts to declare that AMAT is undervalued. We are not going that far and take this result as simply supporting our overall analysis that AMAT is well positioned to produce positive abnormal returns. What confidence do we have in our estimations presented so far?
Intrinsic or Fundamental Risk
To answer the question we need to recall that the value of any company (i.e., the market value of total capital) is composed of two parts: the value of assets in place, [Va] or, the value of the current operations (i.e. the discounted value of the current net operating profits), plus the value of the future growth opportunities [Vg]. In the simplified approach that we use here, this second part is just the result of subtracting the first part, (i.e. the value of assets in place) from the market value of total capital [VT] (as you can see in the table below, [Va] plus [Vg] is equal to [VT] or 100%). The greater the market value of the total capital of the corporation is composed of the value of the current operations [Va], the less significant is the value of the most uncertain part of the total value, i.e. the future growth opportunities [Vg]. For the three companies that we have analyzed the market value comes equally from current operations, the most confident part of its value and, the future growth opportunities.
Market Expectation, Intrinsic Value, Value of Assets in Place [Va] and, Value of Growth Opportunities [Vg %]
Actionable advice: First and foremost, invest or stay invested in Applied Materials. This stock is a rock-solid choice for the coming rebound in worldwide economic activities.
Second, why not take the opportunity to diversify the semiconductor equipment and materials industry part of your portfolio by investing in the above value creators. This part of your global portfolio will leave you sleep at night.