A few weeks ago, I wrote an article arguing that Lam Research (LRCX) is a strong buy at the current valuation. Today I'm making the same argument for Applied Materials (AMAT), Lam Research's biggest competitor.
Applied Materials is the leading provider of semiconductor manufacturing equipment and is quite undervalued at $12.40 per share, in my opinion.
Semiconductor manufacturing is a complex process involving several manufacturing steps. While LRCX is the leader in etching machines, AMAT is focused on deposition equipment. Deposition, besides etching, is a crucial step of the semiconductor production process. Some of the main customers of AMAT are Intel (INTC), Samsung (SSNLF.PK) and the other leading semiconductor vendors.
AMAT also has a service business unit and a solar equipment business unit, which competes against companies such as GT Advanced Technologies (GTAT) and strives to serve solar panel manufacturers such as First Solar (FSLR).
AMAT grew at a reasonable pace in the last decade, though not as fast as its competitors. Sales increased from $4.71 per share in 2000 to $7.12 per share in 2010. This makes a CAGR of 5.61% per annum. Earnings per share grew faster, from $0.31 per share in 2000 to $0.70 per share in 2010 (CAGR of 12.58%).
Value creation and "Buffett Test":
The company creates value for its shareholders and boasts a solid 15.42% average Return on Equity during the same period. Furthermore, management allocated capital so far in a shareholder friendly way and passes the "Buffett Test": the retained earnings (earnings less dividends) generated subsequent earnings growth at an average 20% return. This is less than LRCX, but still very respectable.
Dividends and shares buybacks:
AMAT started paying dividends in 2005 and grew the dividends ever since until 2011. In 2011, AMAT paid $0.30 per share in dividends, which is a very correct yield of 2.41% at the current price per share. Furthermore, the dividends are not at risk and only amount to 17.8% of the Cash Flows from Operations in 2011. AMAT also bought back 17% of its outstanding shares since 2000.
AMAT seems to be cheap at $12.40 per share right now:
- AMAT has $4.80 per share in cash and $1.60 per share of long term debt. The net cash per share is $3.2 (25% of the current valuation).
- AMAT generated an estimated $1.30 of EPS in 2011. Taking into account the cash available, the trailing PER is 7.08. Not as cheap as LRCX, but still quite affordable.
Fair Value (DCF)
The market, which is cyclical, will decline in 2012 and AMAT will not generate the same earnings in 2012 than in 2011. However, taking into account a potential decline of 25% of earnings this year (assuming $1 EPS in 2012), the intrinsic value of AMAT seems to be way over its current price:
- Assuming 5% growth after 2012: the DCF value is $15.67 per share
- Assuming 12% growth after 2012: the DCF value is $19.31 per share
Note: AMAT sales per share grew at a rate of 5% per year since 2000, and the average growth of the semiconductor market is 12% per year.
- Deposition equipment is mission critical. The clients are wary of switching equipment for an unknown supplier. This is a plus for an established, dominating player such as AMAT.
- The number of layers to produce wafers increase in order to accommodate more functions on each chip. Each production line may need more equipment in the future.
- 3D will require more sophisticated equipment, raising the bar for potential contenders.
- Intel recently announced its plan to build next generation 14nm fabs and increase 3D (Trigate) wafer production. AMAT is a key supplier in that process.
- AMAT has a very strong service business unit, which provides for recurring revenues in periods of low capital expenses by the semiconductor manufacturers.
- The market is cyclical: 2012 is forecast to be a bad year, and nobody knows when the demand will pick-up again.
- LRCX recently acquired Novellus, which provides them with a foot in the door at Intel.
Other aspects of the investment
- Insiders sold in 2011 and no recent insider buy is reported.
- The share price has momentum: it moved up from low of $10.13 in December to $12.41 recently.
Like LRCX, AMAT is a strong buy for investors who have the patience and the nerves to hold on through the 2012 weak semiconductor market. Unlike LRCX however, AMAT serves a nice dividend and investors are being paid to wait.