The chip equipment manufacturing industry has been hit hard this year as investors' concerns with the implications of trade tensions with China heighten and forecasts for the semiconductor market turn sour. One stock among the chip equipment group that has been particularly battered is Applied Materials Inc. (AMAT, Financial). The stock that returned 13.9% annually for the past 10 years, plummeted 38% after reaching a high of $61.61 in March.
Applied Materials has been affected by the slowdown in smartphone sales globally and the concomitant reduced demand for semiconductor components. Taiwan Semiconductor Manufacturing (TSMC, Financial) trimmed its projected capital expenditures earlier this year by 13%. China is intent on developing a domestic chip industry, which normally would bode well for Applied, but perils on the trade front now make the company vulnerable to tariffs and retaliatory export controls.
There is nothing unusual about the boom and bust cycle of the semiconductor sector; capital spending on chips has historically been cyclical. The difference in recent years is that the industry’s boom cycle was prolonged thanks to an explosion of demand for memory chips components for smartphones, tablets and game consoles.
The risk for Applied Materials and others, such as Lam Research (LRCX, Financial), is that their fortunes, to a large extent, are inextricably intertwined with the capital spending of semiconductor chip manufacturers. The definitive issue for an undervalued scenario is the extent of this linkage and whether the slowdown in smartphone sales can be offset by promising new markets, such as new chip architecture for artificial intelligence wafers and a redesign for a new generation of memory chips.
Applied has increased its market share among its peers in the industry, which include Lam Research, Tokyo Electron (TOELY, Financial), ASML Holding (ASML, Financial) and KLA-Tencor (KLAC, Financial) —all five corporations account for 73% of industry revenue. In 2012, Applied had a 17.8% market share; today its share has increased to approximately 22%.
An additional area of growth for the company will be demand for the tools required for sophisticated and complex methods of depositing films onto silicon wafers. With the advent of artificial intelligence as well as more dense memory chips, the demand for specialized equipment to manufacture these new components will inevitably grow. According to New Street Research, the market for AI chips could be in excess of $85 billion.
Applied has invested in research and development to try and maintain its edge in supplying new equipment that can create multiple layers for the new, taller chips. The company spent $1.8 billion in 2017 compared to $1.5 billion in 2016.
GuruFocus notes that Applied Materials' operating margins top 94% of all 849 semiconductor manufacturing companies within the industry. According to GuruFocus, additional indexes that reflect well on the company include an earnings yield that is ranked higher that 78% of the Global Semiconductor Equipment & Materials industry.
The consensus among analysts is Applied will earn $3.52 per share in 2019 on revenue of $15.6 billion. After an anticipated period of slow growth, expectations are for profits to rebound 26% in 2020 to $4.45 a share. At a multiple of 10 on those earnings, the current valuation is $45 a share —well above its current price of $34.
Currently, Applied is trading at a three-year low relative to forward earnings. Its current price-earnings ratio is 10.6; at $34.14 per share, the stock is selling slightly above its 52-week low of $30.53 and well below its 52-week high of $62.4.
There is a clear split in authority among gurus with regards to whether Applied is a long- to intermediate-term value play or, given the uncertain outlook for the health of the semiconductor industry, is too risky.
Jim Simons (Trades, Portfolio) increased his third-quarter position by 2,987,712 shares; Lee Ainslie (Trades, Portfolio) increased his position by 850% for a total of 1,701,997 shares. On the flip side of the guru ledger, Richard Snow (Trades, Portfolio), Caxton Associates (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) sold out their positions; Joel Greenblatt (Trades, Portfolio) reduced his holdings by 94%.
Whether Applied is a clear value play will depend on whether one believes the incipient bust cycle of the chip industry can be successfully supplanted by capturing new markets for enhanced chip and memory architecture, the extent and length of the downturn and whether at $34, Applied is still undervalued relative to the industry and market as a whole.
Disclosure: I have no positions in any of the securities referenced in this article.
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