APPLIED MATERIALS INC AMAT
September 25, 2017 - 1:20pm EST by
krusty75
2017 2018
Price: 47.00 EPS 3.23 3.90
Shares Out. (in M): 1,067 P/E 14.5 12
Market Cap (in $M): 50,100 P/FCF 0 0
Net Debt (in $M): -1,928 EBIT 0 0
TEV ($): 48,200 TEV/EBIT 0 0

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Description

 
AMAT Thesis Summary, 9/25/17
 
AMAT is a high quality company trading at a low valuation.
 
AMAT’s quality is demonstrated by its high average returns on capital over a long time period. These
returns are justified because AMAT has unique intellectual property that allows it to design and sell
some of the world’s most technically advanced tools to semiconductor manufacturers. AMAT built this
intellectual property with decades of high R&D spending (~$23bn spent over the past 20 years). AMAT’s
competitive moat is understandable, and it is shown in the company’s operating results.
 
 
Note: returns are shown at a constant 30% tax rate, well above AMAT’s current rate of 11%.
 
The inherent barriers to entry for competition in semiconductor equipment (often referred to as wafer
fab equipment, or “WFE”) have also led to a rational industry structure. Equipment is highly specialized,
and in most of the broader semi equipment categories there are no more than two scale competitors.
Sub-categories are almost always dominated by one player. Overall market share changes are almost
never driven by the displacement of a competitor’s product. Instead, market share changes result
primarily from shifts in spending between categories (e.g., spending on lithography declines and
therefore ASML, the litho leader loses share), and secondarily by winning in new product adjacencies
(e.g., 3D NAND creates demand for a new variation on existing conductor etch technology, and AMAT
captures it rather than LRCX, the other major conductor etch player). The rational structure provides
evidence that this is a high barrier to entry, “natural monopoly”-style industry, and it supports our view
that AMAT’s high returns will continue.
 
 
 
If AMAT’s quality can be so easily explained, then why is the multiple so low? Perceptions of cyclicality
would appear to be the explanation. In fairness to the market, this is a cyclical business, as can be seen
from the longer term history of return performance. AMAT’s revenue and profitability largely depends
on the capital spending activity of its customers. That capital spending activity is discretionary in the
near term, and subject to the broader economic cycle and supply/demand trends within semiconductor
subsectors. However, we are yet to encounter good evidence to suggest that we are currently at an
excessive peak-ish level for semiconductor equipment spending in general, or for AMAT’s earnings in
particular.
 
 
It is true that semiconductor spending will likely reach an all-time high in 2017, but context is needed.
First, and most basically, the current level of spending represents only modest growth relative to both
previous peaks and mid-cycle periods:
 
 
 
The growth rates, considered over time, look undemanding in a category that should, on a normalized
basis, grow well in excess of GDP. Furthermore, we are in the early stages of a technological inflection in
the composition of equipment spending that benefits AMAT. For the last 20+ years, more transistors
were crammed onto each chip using the relatively simple process of “planar shrink”: chopping the wafer
into ever smaller cells using lithography to create ever tighter patterns. A few years ago, this strategy
reached a physical limitation, which first became an issue in memory chips. If the transistor cells were
made any smaller through planar shrink, they would no longer fit enough electrons to accurately hold
the “on” or off position. Therefore, in order to make progress in adding transistors, chip makers began
to focus on building vertically. This vertical building is more materials and equipment intensive, and it
relies heavily on etch (cutting/removing material) and deposition (adding material).
 
The verticalization trend in chipmaking has driven general growth in equipment spending, and AMAT
has been a disproportionate beneficiary given their high market share in dep and etch. AMAT has no
exposure to lithography, the previously dominant application.
 
China is another bolster to semiconductor equipment demand. While China has been a minor player in
semiconductor production for decades, in the past year the government has launched a high profile
campaign to support investment in domestic fabs. This may result in only modest incremental demand if
the industry rationally shifts spending to China from currently dominant geographies like Korea.
However, it could also lead to an extended period of over-building, of which AMAT would be a key
beneficiary. Given that most WFE projections do not contemplate significant Chinese WFE spending
growth, China’s entry into the semiconductor industry introduces attractive demand growth optionality.
 
The underlying demand drivers for semiconductor equipment have also changed. For most of the last 20
years, the PC cycle was the key driver of demand. PC demand was economically sensitive, and
dependent on product cycles dictated primarily by INTC and MSFT. Today, we are in the upswing of
structural growth in demand for semiconductor materials that is driven by a wide range of consumer
and enterprise products, including increasing smart phone penetration in emerging markets, general
“Internet of Things” applications, and escalating demand for data storage. End market diversification
should also contribute to a smoother demand cycle relative to history.
 
In thinking about the growth trajectory, it is also worth mentioning Display. AMAT sells tools, mainly
related to deposition applications, to producers of LCD and OLED screens. The segment amounts to
~10% of AMAT’s earnings power, and is benefitting from similar trends to those in semiconductor. There
is a technological inflection underway as display companies build out OLED capacity, which is much
more capital intensive than LCD. While we are certainly in a display upcycle at the moment, our work
has suggested that elevated display activity should persist for a number of years. Further, AMAT is using
the inflection to develop new tools and gain share. China is also a factor, as it seeks to replace Korea as
the primary provider of displays.
 
  
What does all of this mean for AMAT’s earnings and valuation? AMAT is tracking towards $3.23 per
share in earnings for the fiscal year ending 10/2017. Looking ahead further, management lays out
directional guidance, what they refer to as their “financial model,” with an unusual degree of clarity to
give investors a sense of their outlook for market share, incremental margins, and capital use. Assuming
modest growth in semiconductor and display spending, we think that AMAT can grow revenue at a high
single digit pace. Based on history and management’s commentary, it seems likely to carry at least a
40% incremental operating margin. We also think management will continue to deploy excess cash
(close to $5bn by the end of 2019) to share repurchases, which should reduce the average share count
by ~6% over the next two years. Putting all of this together, we think that AMAT can earn over $4.25 in
EPS in fiscal 2019. The current share price of $47 stands at about 11x that figure: too low relative to the
quality and longer term growth outlook. It is also worth noting that ~80 cents of the 2019 EPS will be
coming from AMAT’s highly recurring services business: applying a 20x multiple to this line would imply
that the rest of the company is being valued at a high single digit multiple of earnings. We think AMAT
deserves at least 15x earnings. Higher multiples could be justified, but we understand it may take time
for the market to accept our view of higher growth and diminished cyclicality. As such, AMAT presents a
relatively low risk return of close to 40% over the next twelve months.
 
What if we are completely wrong on semiconductor equipment spending, and global spend falls back
down to the low $30s billion level? That question brings us to the margin of safety argument. At
spending of $33bn in 2019, we still think that AMAT could generate over $2 in EPS. The current price is
23x that bearish scenario, a multiple at which we would be willing to own a cyclically-depressed high
quality business.
 
We also have a high degree of confidence in AMAT’s management, especially CEO Gary Dickerson. In his
previous role as CEO of Varian, Dickerson oversaw a doubling of market share and 300% share price
growth during a flattish period for the SOX, culminating in the sale to AMAT in 2011. At AMAT, he has
driven share of the WFE market from ~18% to a projected 25% in 2019. Dickerson has also driven
impressive operating leverage: over the 2012 to 2017 period, gross profit has growth at a nearly 14%
CAGR, while operating expenses have grown at just 4%. Meanwhile, we have generally been pleased
with pragmatic capital allocation. When a proposed merger with Tokyo Electron was blocked by
regulators, Dickerson used the disappointment as an opportunity to shrink the share count by more
than 10% with an aggressive buyback program.
 
Catalysts
-Investor day, 9/27/17
-Continued revenue and earnings growth
 
Disclaimers:
We and our affiliates are long AMAT. We may buy or sell shares without notification. This is not a
recommendation to buy or sell shares.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
 
 

 
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

-Investor day, 9/27/17
-Continued revenue and earnings growth
    sort by    

    Description

     
    AMAT Thesis Summary, 9/25/17
     
    AMAT is a high quality company trading at a low valuation.
     
    AMAT’s quality is demonstrated by its high average returns on capital over a long time period. These
    returns are justified because AMAT has unique intellectual property that allows it to design and sell
    some of the world’s most technically advanced tools to semiconductor manufacturers. AMAT built this
    intellectual property with decades of high R&D spending (~$23bn spent over the past 20 years). AMAT’s
    competitive moat is understandable, and it is shown in the company’s operating results.
     
     
    Note: returns are shown at a constant 30% tax rate, well above AMAT’s current rate of 11%.
     
    The inherent barriers to entry for competition in semiconductor equipment (often referred to as wafer
    fab equipment, or “WFE”) have also led to a rational industry structure. Equipment is highly specialized,
    and in most of the broader semi equipment categories there are no more than two scale competitors.
    Sub-categories are almost always dominated by one player. Overall market share changes are almost
    never driven by the displacement of a competitor’s product. Instead, market share changes result
    primarily from shifts in spending between categories (e.g., spending on lithography declines and
    therefore ASML, the litho leader loses share), and secondarily by winning in new product adjacencies
    (e.g., 3D NAND creates demand for a new variation on existing conductor etch technology, and AMAT
    captures it rather than LRCX, the other major conductor etch player). The rational structure provides
    evidence that this is a high barrier to entry, “natural monopoly”-style industry, and it supports our view
    that AMAT’s high returns will continue.
     
     
     
    If AMAT’s quality can be so easily explained, then why is the multiple so low? Perceptions of cyclicality
    would appear to be the explanation. In fairness to the market, this is a cyclical business, as can be seen
    from the longer term history of return performance. AMAT’s revenue and profitability largely depends
    on the capital spending activity of its customers. That capital spending activity is discretionary in the
    near term, and subject to the broader economic cycle and supply/demand trends within semiconductor
    subsectors. However, we are yet to encounter good evidence to suggest that we are currently at an
    excessive peak-ish level for semiconductor equipment spending in general, or for AMAT’s earnings in
    particular.
     
     
    It is true that semiconductor spending will likely reach an all-time high in 2017, but context is needed.
    First, and most basically, the current level of spending represents only modest growth relative to both
    previous peaks and mid-cycle periods:
     
     
     
    The growth rates, considered over time, look undemanding in a category that should, on a normalized
    basis, grow well in excess of GDP. Furthermore, we are in the early stages of a technological inflection in
    the composition of equipment spending that benefits AMAT. For the last 20+ years, more transistors
    were crammed onto each chip using the relatively simple process of “planar shrink”: chopping the wafer
    into ever smaller cells using lithography to create ever tighter patterns. A few years ago, this strategy
    reached a physical limitation, which first became an issue in memory chips. If the transistor cells were
    made any smaller through planar shrink, they would no longer fit enough electrons to accurately hold
    the “on” or off position. Therefore, in order to make progress in adding transistors, chip makers began
    to focus on building vertically. This vertical building is more materials and equipment intensive, and it
    relies heavily on etch (cutting/removing material) and deposition (adding material).
     
    The verticalization trend in chipmaking has driven general growth in equipment spending, and AMAT
    has been a disproportionate beneficiary given their high market share in dep and etch. AMAT has no
    exposure to lithography, the previously dominant application.
     
    China is another bolster to semiconductor equipment demand. While China has been a minor player in
    semiconductor production for decades, in the past year the government has launched a high profile
    campaign to support investment in domestic fabs. This may result in only modest incremental demand if
    the industry rationally shifts spending to China from currently dominant geographies like Korea.
    However, it could also lead to an extended period of over-building, of which AMAT would be a key
    beneficiary. Given that most WFE projections do not contemplate significant Chinese WFE spending
    growth, China’s entry into the semiconductor industry introduces attractive demand growth optionality.
     
    The underlying demand drivers for semiconductor equipment have also changed. For most of the last 20
    years, the PC cycle was the key driver of demand. PC demand was economically sensitive, and
    dependent on product cycles dictated primarily by INTC and MSFT. Today, we are in the upswing of
    structural growth in demand for semiconductor materials that is driven by a wide range of consumer
    and enterprise products, including increasing smart phone penetration in emerging markets, general
    “Internet of Things” applications, and escalating demand for data storage. End market diversification
    should also contribute to a smoother demand cycle relative to history.
     
    In thinking about the growth trajectory, it is also worth mentioning Display. AMAT sells tools, mainly
    related to deposition applications, to producers of LCD and OLED screens. The segment amounts to
    ~10% of AMAT’s earnings power, and is benefitting from similar trends to those in semiconductor. There
    is a technological inflection underway as display companies build out OLED capacity, which is much
    more capital intensive than LCD. While we are certainly in a display upcycle at the moment, our work
    has suggested that elevated display activity should persist for a number of years. Further, AMAT is using
    the inflection to develop new tools and gain share. China is also a factor, as it seeks to replace Korea as
    the primary provider of displays.
     
      
    What does all of this mean for AMAT’s earnings and valuation? AMAT is tracking towards $3.23 per
    share in earnings for the fiscal year ending 10/2017. Looking ahead further, management lays out
    directional guidance, what they refer to as their “financial model,” with an unusual degree of clarity to
    give investors a sense of their outlook for market share, incremental margins, and capital use. Assuming
    modest growth in semiconductor and display spending, we think that AMAT can grow revenue at a high
    single digit pace. Based on history and management’s commentary, it seems likely to carry at least a
    40% incremental operating margin. We also think management will continue to deploy excess cash
    (close to $5bn by the end of 2019) to share repurchases, which should reduce the average share count
    by ~6% over the next two years. Putting all of this together, we think that AMAT can earn over $4.25 in
    EPS in fiscal 2019. The current share price of $47 stands at about 11x that figure: too low relative to the
    quality and longer term growth outlook. It is also worth noting that ~80 cents of the 2019 EPS will be
    coming from AMAT’s highly recurring services business: applying a 20x multiple to this line would imply
    that the rest of the company is being valued at a high single digit multiple of earnings. We think AMAT
    deserves at least 15x earnings. Higher multiples could be justified, but we understand it may take time
    for the market to accept our view of higher growth and diminished cyclicality. As such, AMAT presents a
    relatively low risk return of close to 40% over the next twelve months.
     
    What if we are completely wrong on semiconductor equipment spending, and global spend falls back
    down to the low $30s billion level? That question brings us to the margin of safety argument. At
    spending of $33bn in 2019, we still think that AMAT could generate over $2 in EPS. The current price is
    23x that bearish scenario, a multiple at which we would be willing to own a cyclically-depressed high
    quality business.
     
    We also have a high degree of confidence in AMAT’s management, especially CEO Gary Dickerson. In his
    previous role as CEO of Varian, Dickerson oversaw a doubling of market share and 300% share price
    growth during a flattish period for the SOX, culminating in the sale to AMAT in 2011. At AMAT, he has
    driven share of the WFE market from ~18% to a projected 25% in 2019. Dickerson has also driven
    impressive operating leverage: over the 2012 to 2017 period, gross profit has growth at a nearly 14%
    CAGR, while operating expenses have grown at just 4%. Meanwhile, we have generally been pleased
    with pragmatic capital allocation. When a proposed merger with Tokyo Electron was blocked by
    regulators, Dickerson used the disappointment as an opportunity to shrink the share count by more
    than 10% with an aggressive buyback program.
     
    Catalysts
    -Investor day, 9/27/17
    -Continued revenue and earnings growth
     
    Disclaimers:
    We and our affiliates are long AMAT. We may buy or sell shares without notification. This is not a
    recommendation to buy or sell shares.
    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.
     
     

     
     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    -Investor day, 9/27/17
    -Continued revenue and earnings growth

    Messages


    SubjectRe: Re: thanks for the writeup
    Entry08/21/2018 12:52 PM
    MemberSpocksBrainX

    any thoughts on the quarter krusty?

    past results looked fine but perhaps the cyclical turn is here now?  Granted, I'm looking short-term, but wondering what could move it much higher (beyond the pull of a happy market).  I'm also wondering why they ramped up the buyback - macro looks fine but maybe a better buying opportunties in the future?


    SubjectRe: Re: Re: Re: thanks for the writeup
    Entry08/29/2018 03:16 PM
    MemberSpocksBrainX

    thanks for the reply

    as an ignorant person in this area with no edge, my only pushback would be this:  Per VL, operating margins were 1.1% in 2009 and 15.7% in 2013 and sit at a projected 32.5% in 2018.  From 2002 to 2017, you had two years where cash flow fell, 1 year higher, 1 year lower, 2 years higher, 2 years lower, 2 years higher, 2 years lower, and now 4-5 years higher.   Just 3 years ago the stock stood at $14.3.  After reaching cash flow per share of $1.43 in 2007 it wasn't until 2011 that they hit that height but not until 2015 until it became sustainable.  So you had 8 lost years.  Now, the narrative is this and that number, but how reliable are these WFE numbers anyway (I don't know - I'm literally asking)?   Maybe  2015-2018 is the anomaly?   They said in the last call that 32% of sales were from serving the installed base (so there's a lot of new sales).  I just want the reason it will go higher - like, up 20%.  It isn't higher margins, it isn't capital allocation to buybacks, it isn't higher WFE estimates near-term, so what is it (other than happy market but that will levitate a lot of stocks)?  Per VL, the PE doesn't matter unless you pair the operating margin assumption with it.   To reiterate, i know as much about this area as what the filings tell me, which isn't an edge.   But I do want to invest hard at some point, so...


    SubjectRe: Re: Re: Re: Re: Re: thanks for the writeup
    Entry08/29/2018 07:51 PM
    MemberSpocksBrainX

    Not sure what you mean by "how reliable are these WFE numbers anyway" - are you asking how sustainable/volatile they are or are the figures cited accurate? 

    in the latest call:    So based on the current view of our markets, our evolving strategy and our financial performance, we are confident that we will exceed our goal of earning $5.08 per share in our 2020 fiscal year. Specifically, we expect semi systems revenue to be more than $11.6 billion in fiscal 2020. We believe $50 billion is the new normal for this industry, and that WFE will keep pace with the revenue growth of the industry. We also expect services plus display revenue of more than $8 billion. Within the mix, we see services revenue being above our prior expectation, fully offsetting display revenue, which we expect to be up in 2020 but still below our original target. 

    I don't have access to the historical calls, but how accurate were these pronoucements in the past?  I'm not arguing against the idea, if it matters.  I am the common man, pointing out the obvious.  You can spot the cyclical fears in any number of sell-side reports that even I have access to, and I respect what the valuation is telling me now but want to understand why it is priced the way it is.  Plus, esp. with something like this, I want to err on the side of something a lot worse happening than I expect.  

    I really, really appreciate your thoughts...


    SubjectSome Responses
    Entry09/01/2018 08:21 AM
    Memberkrusty75

    If we were worried about how the next quarter, or even the next year, plays out relative to consensus expectations, we wouldn’t own this (and you probably shouldn’t either).

    Go to any semiconductor equipment management meeting, and there are hordes of analysts from places like Balyasny and Citadel (all due respect) desperately seeking some indication of near term outcomes and trying to parse out slight performance differences between the major players. We will leave that game to them.

    Fortunately for us, the market participants battling it out over the short-term drive consistent and considerable volatility. That volatility has been very helpful in creating entry points for investors with a slightly longer-term horizon, say 3-5 years.

    We agree with Condor’s point: AMAT’s business is cyclical in the near term, but it is a secular grower over the long term. Analyzing long term returns and market share developments would suggest that AMAT’s competitive position is unlikely to be disrupted. And that isn’t to say that the other semicap companies are weakly positioned: almost all of semicap equipment has been carved up into monopoly or duopoly submarkets, which is nice.

    Perhaps at odds with Condor, we are somewhat skeptical that a $50bn WFE environment, and earnings power north of $5 per share, is the right assumption to capitalize today. But you don’t need that to get to earnings assumptions that make AMAT cheap in absolute terms. 9x is absurdly cheap … but a business like AMAT would still be cheap at a low/mid-teens multiple of mid-cycle. Getting to a mid-cycle earnings estimate of less than $3 requires punitive assumptions.     

     

    Another critical point to keep in mind: while AMAT is cyclical, it is capital-light. Even in the year ended October 2009, AMAT did not go cash flow negative. This resilience gives us the ability to take the long view. This also ties into the topic of the buyback: it isn’t a sign that management is taking a particular view on near term perceptions or outcomes. Instead, they are in the process of shifting the balance sheet to a leverage position that makes more sense relative to the nature of the business. The catalyst for this shift was tax reform, which reduced AMAT’s stranded offshore cash issues and thereby provided management with newfound flexibility.  

     

    Has anyone heard a good case for major disruption in semicap equipment that would derail the long-term growth prospects? If so, we would love to hear it.

    Also, on the mid-cycle earnings point, this comment from the CFO at a conference back in February may be of interest. Note that 2017 EPS was $3.25:

    Our fundamentals look good, so our view is not a downturn in 2019. But if we found ourselves in an unexpected situation, we obviously model lots of scenarios to make sure we can be nimble and disciplined if and when we encounter that situation. And so one of the scenarios we model, let's say it's a $40 billion WFE in 2019, and we advertised at our Analyst Day a few months ago, that we would be at a 26.5% market share in 2020. So in 2019, we'll be 1 click short of that, so let's say 25% market share. $40 billion WFE, 25% market share. We've got a services business that probably won't grow 15% in a year like that, but it will be up a bit and we've got a strong display business. When you put all of that together, we're going to be well north of $16 billion from a revenue standpoint. Flowing that through will be around 28% operating margin. And so from an EPS production standpoint, we'll be nicely north of where we were in 2017, which was the all-time high for the company. And so we feel good about our ability to withstand a downturn. Again, it's not our likely scenario, but if that's the scenario we find ourselves in, I think we're prepared to manage the business and produce strong results for investors.”

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