The market seems to have severely punished most companies related to the PC industry, which everyone seems to bet, is going to be cannibalized by tablets and smartphones. But how bad is it really going to be for the traditional PC (desktop and laptops) industry? The market seems to believe that it's the end for PC's as we know it. I beg to differ. While I do believe that the PC industry is going to decline - maybe significantly so (Yogi Berra would aptly say "The future ain't what it used to be") - I would bet that it's not going to disappear. Most software companies are already focusing on producing apps and operating systems which are adapted for the "cloud" and mobile era. Windows 8, Microsoft Surface, fears on Facebook on being unable to efficiently monetize on mobile users - those are just examples that show how everyone is paranoiacally trying to get a piece of the new era of consumers' IT products, following the lead of companies such as Apple, Qualcomm and ARM Holdings.
All of these changes mean that new hardware solutions will have to be developed and manufactured. It means that the demand for current product lines will decline significantly or become outright obsolete. Some semiconductor companies will adapt and thrive, some will become extinct, and some new competitors will emerge. As a rule of thumb, technological changes tend to affect technology-enabled companies (think Blockbuster vs Netflix) more than they do technology-producers (think Qualcomm).
I think Applied Materials (NASDAQ:AMAT) is a good example of a company that might benefit from many of these changes: While AMAT is exposed to the PC industry (and will thus suffer along with many of its semiconductor clients), AMAT is also positioned to profit from these changes, as the semiconductor industry deploys money for badly needed capital expenditures - so as to compete in the manufacturing of more efficient, mobile, and wirelessly connected devices. AMAT is the world's largest supplier of semiconductor manufacturing equipment, meaning it's the single biggest provider for the technology producers.
Applied Materials has 4 main business segments:
Silicon Systems Group Segment (51% sales): Equipment and services for use in the front end of the semiconductor fabrication process. Applied offers systems that perform most of the primary processes used in chip fabrication. Clients: integrated device manufacturers and foundries to build and package memory, logic and other types of chips.
- Applied has the industry's largest portfolio of technically advanced products for building smaller and faster transistors, copper-based chips' manufacturing, and low K Insulators, all of which are key to lower energy consumption devices and faster chips, preparing AMAT for the industry's focus on smartphones/tablets/cloud devices.
- Leading innovator of manufacturing equipment for 3D Integrated Circuits (microprocessors), with the potential of drastically reducing power consumption (10-100 times), and the same power in less space. Presently 3D IC is being pursued by major semiconductor companies, but none is actually mass producing chips with this technology.
- Over time, the semiconductor industry has migrated to increasingly larger wafers to build chips. Applied offers a comprehensive range of 300mm systems (currently the biggest standard) and is a leading innovator in 450 mm systems, the future standard.
-Leading portfolio of systems allowing for 22 nm semiconductor manufacturing process. Highest expenditures in R&D in the next manufacturing technologies (14, 10 nm).
- Applied has the biggest systems and tools portfolio in the world, helping semiconductor manufacturers on every step of the manufacturing process.
- Applied profits from technological innovation looking for more energy-efficient chips, as their use become even more prevalent in everyday life. As the cloud pushes for more powerful and energy efficient tablets and smartphones, Applied is researching and innovating equipment and technologies that will enable manufacturers to produce such hardware.
Applied Global Services Segment (23% sales): Products and services designed to improve the performance and productivity of the fab operations of semiconductor, LCD and solar PV manufacturers. Trained customer engineers and process support engineers are deployed in more than a dozen countries. These engineers are usually located at or near customers' fab sites and service over 37,000 installed Applied systems, as well as non-Applied systems. AMAT tends to establish long term contracts with many of its foundry and fab clients.
Display Segment (7% sales): Equipment for the fabrication of flat panel displays. Applied is also extending its core LCD equipment technology into new mobility display segments that require smaller, high-performance LCD or organic LED (NASDAQ:OLED) screens and touch capability. AMAT projects 2-digits long term growth rates for this segment, though I would expect flat sales for the next couple of years, given macroeconomic fears and contracting capex.
Energy and Environmental Solutions Segment (19% Sales): Manufacturing processes significantly similar to many of the semiconductors industry product lines, have allowed AMAT to apply it's expertise in the Solar Energy industry. Applied has developed a portfolio of solar PV wafer and cell fabrication technologies, making it the leading supplier of c-Si equipment worldwide in terms of revenue. In addition to innovative technology, these systems offer key manufacturing benefits to customers in high productivity, advanced ultra-thin wafer handling, and extensive automation.
- The solar energy industry currently finds itself in a cyclical downturn mainly caused by a global oversupply of solar cells, coming from government-subsidized chinese producers, dumping their production, and an overall excess capacity. The medium term looks bleak for the industry, with hardly any companies making profits. However, experts agree that the potential for significantly more efficient cells (compared to the relatively primitive current technologies) is huge. Applied will suffer along with this decline. However, long term prospects are fairly optimistic for the solar energy industry, and Applied will probably be a beneficiary of technological advances.
Sales by geographical region (70% of which comes from Asia, which concentrates most of the semiconductor foundries of the world):
- China 24%
- Taiwan 20%
- Korea 12%
- North America 19%
- Europe 11%
- Japan 9%
- Southeast Asia 5%.
- Samsung 12%
- TSM 10%
- Intel 10%
- Financial position is excellent: $2.16 bil in cash, $5.86 bil in current assets, $2.4 bil in current liabilities and $5 bil in total liabilities. Current ratio: 2.44. Leverage Ratio: 1.60.
- Net Margin - 10YAverage: +10.5%. Min: -6%. Max: +18.3%. Only 2 years of net losses.
- FreeCashFlows-to-Sales: 10YAverage: +14.8%. Min: +1.4%. Max: +21%. AMAT has performed exceptionally well in the last decade, with positive Free Cash Flows every single year, a pretty neat feat for a cyclical company.
- ROE 10YAverage: 12%. ROE 5YAverage: 12.8%.
- R&D-to-Sales 10YAverage: 14.5%. TTM research and development's expenditure stands at $1.2 billions, being by far the highest R&D budget in the industry.
What might go wrong? And other risks:
- Silicon systems segment is tied to the highly cyclical semiconductor industry. Applied will closely follow the industry's trend, expanding dramatically during upturns in which fabs invest heavily in capex, and contract heavily during downturns. While AMAT will fluctuate, it's peers will probably fluctuate more intensely, given AMAT's more diversified customer base.
- To maintain its market share, Applied must compete successfully in various segments with numerous competitors that only specialize in their submarkets. Therefore, Applied may not have the best-of-breed product in every segment in which it competes.
- AMAT is the biggest player in a highly fragmented industry, and it's not very likely that it will be able to increase it's market share significantly, except for acquisitions. Some argue that AMAT's expanding core responsibilities might trigger customer backlash over depending heavily on any single provider.
I think the market is punishing's Applied Material for the following reasons:
- Too vulnerable and exposed to the PC market.
- My take: AMAT is indeed exposed to many fabs and semiconductor companies (Intel & TSM combined compose 20% of AMAT's sales). However, those companies, and most of the semiconductor industry is investing heavily in new generations of consumer's electronics, mainly tablets and smartphones. I guess(timate) that the semiconductor industry will continue growing in the future: The PC's will not disappear, they will not decline, they will not grow, sales (cyclically averaged) will stay flat. Mobiles and tablets will be the expansionary force that will keep the semiconductor growing.
- Solar energy sucks.
- My take: That's right completely right, but I daresay not in the long run. China derives 70% of its energy from coal burning, and its coal reserves will not last more than 30 years, given current consumption levels. This has pushed China's government to heavily subsidize alternative energy sources, especially solar energy, to the point in which the industry finds itself with excess capacity. Chinese producers are dumping their productions all over the globe, eroding profitability for almost all producers. The solar cell industry will probably be in pain for the next 2 to 3 years, until newer for efficient solar panels are developed and companies can compete in that newer technological environment. AMAT will probably benefit from technological changes that require new capex. Long term, AMAT's management projects 2-digits growth rate for the segment, and they are probably right, though for the short term they will be hurt, which management already recognize with a big write-down in it's Energy & Environmental Solutions division.
- The Silicon Segment competes in a highly fragmented market, with a high number of small, specialized competitors. Applied must maintain its technological innovation to keep up with the latest trends in chip manufacturing.
- AMAT has the highest R&D budget in the whole industry allowing it to reasonably compete in terms of innovation with many of its competitors. Also, its size and strong balance sheet will allow it to perform acquisitions, to an extent unimaginable for the competition. Both features should help AMAT stay in the forefront of technological advances. Even more so, most semiconductor manufacturing companies are of significant size, and Applied not only can perform exceptionally well as the only one-stop-shop in the industry: Applied's size (biggest single company among semiconductor equipment producers) makes it the ideal contractor for big companies such as Intel, Samsung, and TSM, given that AMAT is one of the few companies capable of responding effectively when big orders are requested.
My base scenario assumes the following (forecast period 2013 - 2022):
- Silicon: Sales fall from $5.3 bil (2012) to $2.7 bil in 2014, and then grow at 8% for the forecast period. Operating margins: 30% (below historic 33%).
- Services: Sales fall from $2.4 bil (2012) to $1.9 bil (2014), and then pick up at 9% till the end. Op margins: 18% (vs 20% historic)
- Display: Sales fall from $750 mil to $600 (2014), and then grow at 11%. Op Margins of 20% (vs historic of 21%).
- Energy: Sales fell from $1.9 bil, to $0.8 bil in 2014, and then pick up a growth rate of 15%. Operating margins of 20% (vs historic of 23%).
- Capex stays at 4% of sales.
Estimated Free Cash Flows (millions):
2022: $2600 + Terminal value of $27000
(To put it in context: The average yearly Free Cash Flow in the last decade has been slightly above $1.3 billions.)
Present Value of Base case (@10% discount rate):
$20.800 millions (x 8.5 2012FreeCashflows - x 10.8 2012 Earnings)
Per Share Fair Value: $16.75
I would argue that there is more upside than downside to the company for the reasons previously mentioned, which leave me with a range of potential valuations that start at $17 bil and an upside of $25 bil. (Per share range of values: $13.75 - $20.25)
The company presently trades at $13.2 billion dollars ($10.87 per share), leaving a margin of safety.
Disclosure: I am long AMAT.
Additional disclosure: I'm a novice investor trying to get feedback on my certainly cursory and primitive analysis of companies. I REALLY MEAN NOVICE.