Semiconductor manufacturing equipment is a highly dependent industry; capital spending by chip manufacturers decides the demand for equipment. This industry is cyclical in nature and trends in consumer demand for electronic devices determine the semiconductor manufacturer capex, thereby affecting the sales of the equipment. Currently, the industry is in a declining trend, where the chip manufacturers are reducing capital spending. As per a Gartner report, the chip manufacturer industry reduced its equipment purchase spending by 16.1% year over year in 2012, and it is expected that this spending will reduce 8.5% year over year in 2013. The lower spending has affected the sales of semiconductor manufacturing equipment.
We are discussing Applied Materials (AMAT), a leading player in the semiconductor manufacturing equipment industry, and how its recent merger agreement with Tokyo Electron is creating positive synergy for sustaining growth.
Semiconductor equipment has a concentrated customer group - a few players do most of the capital spending. Therefore, a slump in the equipment market and the presence of a concentrated customer group has resulted in consolidation of semiconductor equipment suppliers due to mergers. This industry consolidation is aimed at deriving synergies by consolidating equipment supply during weak demand and deriving cost efficiencies in the manufacturing process. The following are the most noticeable deals in the industry:
ASML Holdings (ASML)
Lam Research (LRCX)
Varian Semiconductor Equipment
Continuing with the trend, on September 24, 2013, Applied Materials announced an all-stock deal to merge with the third biggest player in the industry, Tokyo Electron (OTCPK:TOELF). The combined entity will be incorporated in the Netherlands and will maintain a dual listing in the Tokyo Stock Exchange and the NASDAQ. This deal will provide an operating cost reduction worth $250 million annually after the end of the first year post merger and will increase to $500 million annually by the end of the third fiscal year after merger. The deal is expected to close by the second half of 2014, and we believe that it will have low risk in regulatory clearance as Applied Materials and Tokyo Electron have very few products that compete in the same market segment. Since each company has dominance in different segments, this merger will broaden the presence of the newly formed company in different market segments. The following is the share of both companies in the different market segments in 2012:
Deposition - Epitaxy
Etching - Silicon
Deposition - PE CVD
Deposition - PVD
Etching - Dielectric
Total Market share
Source: Gartner Data
The combined entity will be worth $29 billion in market cap, and we believe that combining expertise will increase the new entity's product and technologies portfolio, which will provide a high value to customers. In the world of changing technological environment, it is important to fulfill the needs of customers, which are demanding advanced equipment for coping with the demand of changing chip manufacturing processes. The new company formed by the merger will also execute a $3 billion share buyback program in the coming 12 months. This will be beneficial for investors in terms of cash return, and it will reflect as growth in the company's EPS.
This deal has come at the right time, as the semiconductor manufacturing equipment industry is expected to move in an upward trend in 2014 due to increased capital equipment spending of 15.8% year over year, as per Gartner. This trend will continue in 2015, with growth of 17% year over year.
Shift in the balance of power
The semiconductor equipment industry's customer segment is mirroring the consolidation trend; chip manufacturers like Intel ([[INTC]]), Samsung ([[SSNLF.PK]]), and Taiwan Semiconductor Manufacturing ([[TSM]]) control nearly 50% of semiconductor equipment purchases. This has created a balance of power in only a few hands, so it is important to adopt a customer centric strategy, providing leading edge technology as per customer demand.
The chip manufacturing industry requires huge capital spending in building and managing plants. In addition, there is continuous need for R&D investment for coping with the changing technological scenario. Therefore, the industry has a limited number of players that invest heavily in providing cost effective technology.
Intel and Taiwan Semiconductor Manufacturing, or TSMC, both are currently testing their small size chips, which will have significantly more transistor in the single chip, thus performing more functions with less power consumption than a current 28 nm, or nanometer, chip. Both companies are expected to increase their spending in terms of R&D and equipment purchase to roll out this new chip in the market. Therefore, there is a new opportunity for equipment manufacturers to capitalize on the expected growth in the spending on equipment purchases.
The merger of Applied Materials with Tokyo Electron will create a dominant player in the semiconductor manufacturing equipment supplier market. The industry is currently facing a downward cyclical trend, and with consolidation of the major players, equipment suppliers like Applied Materials will benefit from operating cost synergy. It will also help in developing technology to cater to the changing needs of a concentrated customer group. Applied Materials currently has a negative trailing twelve months diluted EPS of 0.37, and with a forward P/E of 15.75 for fiscal year ending Oct. 28, 2014, investors can expect earnings growth. After the merger, the newly formed company will execute a $3 billion stock repurchase program, which is expected to be EPS accretive and will generate returns for investors.
Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Rohit Gupta, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.