Are you reading this on a smart phone, table, or computer? Then you can thank Applied Materials (AMAT, Financial) for that, because it doesn't matter what device you are holding, Applied is involved somewhere in the manufacturing process.
When are you going to stop using that smartphone, tablet or computer for your day-to-day business or personal activities? Chances are that the answer is never, and as more of devices come online, which they will, Applied just becomes more important to the industry and society.
Of course, since I first wrote on Applied Materials in August, shares have fallen by more than 20% on weak guidance, which led to widespread analyst downgrades from Bank of America Merrill Lynch, Goldman Sachs, Citigroup, Morgan Stanley and Deutsche Bank. The analysts downgrades came as the company announced its plans to limit production expansion, which will mean earnings in 2018 will come in close to $4.40, but in 2019 will likely fall to around $4.00 per share, in part due to the higher tax rate on foreign income that takes effect.
Keep in mind, these expectations are not for a net loss. Analysts simply expect slightly less profit and a small decline in sales. That said, chip manufacturing is a tough business. Companies are under intense pressure to put out better products every year, while commoditized prices tend to decline over time.
Further, cyclicality means in good times oversupply leads to lower prices and profits. Companies that can remain profitable and withstand the short-term volatility are usually first in line during the next cycle.
For Applied Materials, its leadership position allows it to survive and prepare for the next boom period. And, make no mistake about it, another boom period will be upon us very soon thanks to developments in big data, the Internet of Things (IoT) and artificial intelligence.
Applied Materials has also been buying back its stock at an incredible rate, repurchasing 25 million shares in the second quarter alone, and spending $1.25 billion in the process. These buybacks will lift the stock price and dividend payout long term because the growth drivers for chips (some listed above) remain firmly in place. The company still has north of $5 billion under its current authorization plan. At its current price, if fully realized, the program would decrease Applied's shares to around 830 million. That is one reason analysts expect earnings to exceed $4.00 per share this year.
From a business standpoint, Applied's engineering solutions and core materials are used in nearly every part of the chip-making process, giving the company a wide economic moat. While demand for chip-embedded devices fluctuates over time with equipment for manufacturing following suit, leading to cuts in capital expenditures at its clients' accounts, Applied spends over $1.5 billion on research and development to create and build new tools, technology and processes to maintain its dominant position in the market.
From a financial standpoint, the last 10 years have been very good for Applied Materials. The company has doubled sales, tripled income and positioned itself as the leader in an industry that continues to grow. But high profit margins (19.9%), return on equity (44%), return on assets (18%) and return on invested capital (27%) will likely fall in the coming years as the business cycle enters the trough, but that shouldn't be cause for alarm. Applied's tools and customer engineers are stationed in nearly every chip-manufacturing facility in the world. So long as semiconductors are necessary to the technology that powers our society, Applied Materials is likely to be an integral part of every company's supply chain.
With the stock under $35 and the company set to earn over $4.00 per share in 2019, investors that buy in now are getting the stock at a 30% bargain.
Disclosure: I am not long/short any stock mentioned in this article.
