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  • Brett Schafer

Not So Deep Dive: Applied Materials Stock

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Show Notes

(Ryan) What they do: Applied Materials provides manufacturing equipment, services, and software to the semiconductor and display industries. The way I understand it, Applied is one of the world’s leading material engineering (science of creating and modifying materials) firms. I went on Youtube to figure out how the process actually works, and it’s pretty fascinating. Basically, they are manipulating materials on an atomic level but at an industrial scale through several different processes called deposition, removal, modification, and analysis.

Now I can’t really do the process justice, so we’ll link to a video that the company published in the bio. But Applied materials sells primarily to chip manufacturers or display companies. So their 2 largest customers are Samsung and Taiwan Semi. And Applied breaks its revenue down into 3 segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets (think high tech displays like TV’s or AR/VR tools).

(Ryan) History: Applied Materials was founded in Santa Clara, CA in 1967 by Michael McNeilly and a few others, and they were really one of the pioneers of the microchip industry. They were initially funded with some seed money from local investors.

During the early years of semiconductors, the manufacturers would largely build their own equipment, but Applied changed that and stepped in as a fabrication system supplier. And it didn’t take long for AM to grow either, they IPO’d in 1972 and by 1975, they were pretty much already expanding globally. There were however, several semiconductor industry “recessions”, and at several points Applied almost collapsed.

Today, they are now a global leader in nanomanufacturing with offices and direct sales teams all over the world.

(Brett) Industry/Landscape/Competition:

  • The industry is semiconductor equipment

  • Applied Materials management is expecting $100 billion in Wafer Fab Equipment spending in 2022 that will be slightly higher in 2023

  • For Applied Materials, to track demand you should look at capital expenditures from TSMC, Samsung, and Intel along with their capex forecasts

  • They are the largest Semicap company by revenue (ASML larger market cap)

  • Competitors: Lam Research, ASML, KLA Corporation, Tokyo Electron are competitors in the semiconductor equipment market

  • However, it should be noted that a lot of these “competitors” serve different niches and aren’t truly competing for bids from TMSC, Samsung, and Intel

(Ian) Management and Ownership:

  • Gary Dickerson is the President and CEO and has served in those roles since 2012-2013.

  • Prior to Applied, he was CEO of Varian Semiconductor Equipment Associates which was acquired by Applied in 2011

  • He’s consistently ranked as one of the top CEOs in the world

  • Since he became president in 2012, it has more than 10-bagged

  • He’s known for prioritizing innovation and product development

  • R&D spend has risen significantly as a proportion of expenses over his time at Applied

  • This is a highly paid executive team (Dickerson got $35mm in total compensation in 2021, mostly stock awards)

  • Vanguard and Blackrock are the largest shareholders (institutions own over 80% of the company).

  • Insiders own < 0.5%, but Dickerson owns over $100mm, has been selling some

(Brett) Valuation:

  • Market cap of $110 billion, ticker AMAT

  • EV of $107.5 billion ($7.76 bil in cash/investments, $5.4 bil in debt)

  • EV/OI of 13.8

  • EV/FCF of 18

  • Important for a company like this to look at income and cash generation from multiple years since demand can be cyclical

  • Overall thoughts on valuation?

(Ryan) Earnings:

  • Just wrapped up their 1st quarter, so their fiscal calendar is a little off

  • But in 2021, Applied Materials generated $23B in revenue, up 34% YoY

  • They also generated just under $5B in FCF, which is a 21% FCF margin

  • And they continue to expand their profitability, gross margins have grown steadily

  • And there’s been a pretty constant theme throughout recent earnings reports. They’re seeing record demand, but fulfilling that demand has been tough due to supply shortages of certain silicon components.

  • Even with the shortages persisting, AM had a good first quarter of growth (20%+ on the top line).

(Ian) Balance sheet and liquidity:

  • Solid balance sheet

  • $5.7B in cash

  • $5.5B in long-term debt with low single digit interest rates

  • About $240mm in annual interest expense (34x EBIT to Interest Expense)

  • Have access to more borrowing if they desire

Anecdotal Evidence:

  • (Ryan) I’m probably utilizing their work right now in some way.

  • (Brett) Nothing.

  • (Ian) Nothing

Future growth opportunities:

  • (Ryan) IoT. At this point, I don’t see how their would be any sort of reversion in the number of internet connected devices. It feels like a secular trend. You name the device, it’s pretty much becoming internet connected. SmartTV’s, phones, watches, potentially glasses, cars, and I’m sure I’m missing plenty. As long as the end markets grow, Applied should as well.

  • (Brett) Automotive industry. If you believe EVs are the future, that will raise the demand for semiconductor output, which will raise the demand for Applied Material’s products and services. Also want to mention Intel’s recent investments and U.S. and Europe wanting to bring manufacturing back home

  • (Ian) The world wanting more redundancies in supply chains. Geopolitical tension may increase Applied Material’s business, may have been some of the boon in 2021.

Highlights and lowlights:

  • (Ryan) Highlights: Good history of being shareholder friendly. Strong demand as far as the eye can see and I imagine there are high barriers to entry here. Lowlights: Customer concentration. Not really up to them, but 35% of their sales come from 2 companies and the China/Taiwan issues could have adverse impacts on AM.

  • (Brett) Highlights: Strong competitive position, great end market growth (cloud, automotive, machine learning), and history of strong capital allocation. Lowlights: Have no reading on if/when the semiconductor cycle ends, geopolitical risks (and benefits, to be fair), very hard to evaluate them vs. the competition as a generalist.

  • (Ian) Highlights: “Today, 9 of the 10 most valuable companies in the world either design or build chips.” Strong FCF generation. Clear path to returns and secular tailwinds. Lowlights: I don’t know what I don’t know

Bull case:

  • (Ryan) I don’t think they need much to go right for this to be a good investment. They returned $2 billion to shareholders in the last quarter through repurchases and dividends. Annualized that would be about a 7% shareholder yield. If in 5 years, revenue hasn’t grown at all, this still wouldn’t be a horrible investment.

  • (Brett) End market steadily grows, they can retire 5% of shares a year at these prices. FCF/s compounds at 12% - 15% over the next decade.

  • (Ian) Current 5.5% FCF yield, if it can maintain its FCF generation, then at worst scenario it can return significant amounts of cash to investors through buybacks or dividends, which it seems willing to do. If it can actually grow FCF at 5% per year over the next five years and it maintains current multiple, looking at 10-11% return per year.

Bear case:

  • (Ryan) We’re at the peak of a semiconductor cycle. I don’t think we are, but if that’s the case then AM’s ability to return cash to shareholders will obviously be diminished. I think a more pressing risk is that the supply chain problems actually get worse, and start to really impact AM’s ability to fulfill demand.

  • (Brett) Geopolitical risks come back to bite them (i.e. banned from China or something like that) or we get a giant bullwhip effect within the semiconductor industry.

  • (Ian) Technological change, and one of the big competitors supplants them, or demand temporarily dries up because manufacturers get caught in political tensions. Revenue and FCF declines and it get rerated.

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Disclosure: The author and podcast guests are not your financial advisors. Ryan Henderson and Brett Schafer are general partners and portfolio managers at Arch Capital. Clients of Arch Capital may hold securities discussed on this show.

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