Description

I believe shares in Applied Materials (AMAT US) are undervalued and are a compelling multi-year investment. Applied Materials is the largest, most diversified semiconductor capital (semicap) equipment business globally.  It is a high-quality business.  AMAT was written up on VIC a few years ago, and I also wrote up its peer KLA (KLAC US) in 2019. I recommend looking at some of these prior VIC write-ups for a refresher on the business model. 

I structured this note by first laying out some context on the main perceived risk (China) and then explaining why that risk appears to be overly discounted in the share price.  

Context on role of China in semiconductors:

1. AMAT derives 31% of its revenue from customer fabs located in China, up from c. 10% in 2012. Overall, sales to fabs located in China drove c.60% of AMAT’s $ revenue growth since 2012.   The experience of AMAT’s main peers (Lam, ASML, KLA and Tokyo Electron) has been similar.  No wonder then that a deteriorating US-China relationship and tighter controls of semiconductor technology exports to China are the #1 risk whenever semicap stocks are discussed.  

2. Half (ie c.16% of the semicap market) of the semicap industry’s sales to fabs located in China are to “domestic China” customers such as SMIC; the other half is to the China fabs of international customers such as Intel, TSMC and Micron.  The former is growing the fastest.  

3. Overall, roughly c.15% of global semiconductor manufacturing capacity is physically located in China at the moment.

4. Although only c.15% of semi fabs are located in China, China “consumes” 60% of global semiconductors by value.  Roughly half of that 60% is from packaging and assembly of finished electronics products in China but destined for export outside of China.  

5. For decades, it has been a priority for China’s government that China becomes self-sufficient in semiconductors, limits its reliance on foreign semiconductor technology, and cultivates Chinese semiconductor manufacturers, equipment manufacturers and design companies that are competitive on a global arena.  As part of a “Made In China 2025” plan announced by the government in 2015, the government said China will spend $150 billion in pursuit of these goals in 2015-2025.   China’s ambitions in different segments of the semi market are being realized through different companies, the most important of which are YMTC, SMIC, AMEC and HiSilicon/Huawei.  YMTC wishes to become a globally-competitive memory player; SMIC has aggressive plans to close its technology gap vs TSMC and Intel; AMEC is a Chinese semicap player with long-term ambitions to match the technology of players such as Applied Materials and Lam; and Huawei’s HiSilicon is China’s leading fabless semi design player (significantly hamstrung by the US government’s hostility towards Huawei).  Despite these ambitions, today China continues to be largely dependent on Western technology provided by players such as Applied Materials, and this has been corroborated by years of growing sales of semicap to ‘domestic China’ fabs. 

6. Either due to a worsening relationship with China or due to a growing appreciation of the importance of semiconductor technology for LT national security (or both), the US has been increasing the restrictions on selling to China.  These restrictions were initially focused on Huawei/HiSilicon and the use of US semi technology in potential military applications, and Applied Materials and other Western semicap vendors mostly didn’t experience any material revenue headwind from these restrictions (though the rules have been adding new hoops for the companies to jump through e.g. having to secure new export licenses).  Given the importance of China to semicap sales as well as the entire electronics value chain globally, it is sensible to put pencil to paper and think about some scenarios of how these restrictions may develop next. 

In a scenario where AMAT can no longer sell to China domestic fabs, it still has $2+/share of earnings power:

Below are AMAT’s LTM (last 12 months) consolidated figures:

Revenues $16,268 million

GAAP EBIT $3,946 million (24% margin)

GAAP diluted EPS  $3.57 (cash conversion to FCFE is high, 85%+)

In the last 12 months, AMAT’s sales to China-located fabs equaled $5.1 billion (or 31% of total revenue), and approximately half of that ($2.5 billion, 16% of total revenue) was sold to domestic China fabs.  If the relationship between China and US deteriorates to such an extent where AMAT’s shipments to domestic China fabs go to 0, then AMAT loses $2.5 billion of revenue going forward.  I.e. AMAT’s new ‘normalized’ annual revenue would be $13.8 bil.   The loss of EBIT and FCF would be less due to AMAT’s operating model and ability to flex costs - this is supported by AMAT’s EBIT margins not changing meaningfully in the past 5 yrs despite a significant increase in sales.  For conservatism, I assume a 500 bps EBIT decremental impact (EBIT margin declining from 24% to 19% normalized).  Thus, pro-forma for sales to China domestic fabs going away forever, AMAT’s EBIT drops to $2.63 billion.  After net interest of $180 million and a 20% tax rate (AMAT’s actual tax rate is closer to 16% but I am trying to be conservative and build in some cushion for possible tax increases under new administrations), this results in $1.95 billion of net income, or $2.11 of EPS power.  The share price currently trades at slightly below 30x that number.  30x P/E is inexpensive given that (i) a rather ‘bad’ scenario would have just occurred and much of the uncertainty would be gone, (ii) quantitatively, Applied Materials is a very high quality business with ROE consistently north of 20%, with high cash conversion, good earnings quality, low capex needs, and a track record of a constantly shrinking share count, (iii) qualitatively, even if Chinese fabs were shut off from the rest of the world, Applied Materials is still an oligopolist furnishing very important products that enable the rest of the world to enjoy technological progress (faster, more powerful, smaller, less energy-intensive electronics).  It is hard to make predictions about what the world will look like 20 or even 10 years from now, but I think it is reasonably safe to say that technology and electronics will play an even bigger role in the lives of consumers and businesses everywhere. 

And - if the relationship with China and the US improves and/or AMAT successfully navigates any further export controls such that sales to domestic China fabs do not drop, the current valuation level of mid-teens EPS is too low for a globally-important, high-ROE % technology business with low reinvestment needs and the geopolitical overhang now removed.  

In an even more bearish, “Cold War” scenario where nobody in the semi & electronics industry does any business with China ever again, AMAT still has $1.24/share of earnings power: 

I think it always makes sense to stress-test any investment with extreme, ‘nuclear strike’ type scenarios.  Imagine a new ‘Cold War’ begins tomorrow.  In this new ‘Cold War’, AMAT is prohibited by law from selling to any fab located in China (including the China fabs of customers like Intel or TSMC) and major international electronics companies like Apple or Samsung just cease selling anything to China (ie sales of the iPhone in China go to zero).  I project that AMAT’s revenue would drop from $16.3 billion LTM to $10 bil normalized.  AMAT can survive this structurally because less than 20% of all fab capacity is physically located in China (i.e. most of AMAT’s installed base and many of AMAT’s employees are in Taiwan, South Korea and Singapore) and because we know that AMAT’s cost structure and headcount at $10 billion of sales only a few years ago enabled it to be nicely profitable.   

The way I calculate the new AMAT revenue number of $10 billion is as follows: the disclosed total China sales ($5.1 bil) go to zero, and the remainder goes down by 10% (I assume that all international customers such as Intel and TSMC would have to cut their normalized manufacturing capacity in response to the removal of China as an electronics export market as well as the global economic recession that would likely take place due to all the supply chain chaos).  Assuming 16% EBIT margins (down from 24% currently; note that the last time AMAT was at $10 billion of revenue, its EBIT margins were 18-19%, so this seems like a reasonable assumption), this ‘Cold War’ AMAT would generate $1.6 bil of EBIT, $1.15 bil of net income, and $1.24 of diluted EPS.  In other words, at the current share price of c.$62, Applied Materials is trading at 50x “Cold War” earnings.  Given the economic malaise that a new Cold War could unleash upon consumers, perhaps 30x P/E is a more fair valuation level, and thus AMAT could have 40% downside from current share price levels. If such a ‘Cold War’ was to truly occur, perhaps all of us would have other (more important) things to worry about... though please do note that AMAT might actually enjoy some unexpected boons.  A world where supply chains are more localized, nations distrust each other and increasingly view the next warfare theatre to be technological, semiconductor capital equipment might gain new appreciation.  For instance, there is a temptation to dismiss the recent Arizona fab investment plan by TSMC as nothing more than a ploy to get political goodwill, but if it is a real sign that supply chains are localizing and duplicating (more fabs + more equipment + more tax breaks for fabs and equipment), Applied Materials could be a significant beneficiary.  

Conclusion: 

As long as Applied Materials continues to be run by competent managers, its shares have little fundamental long-term downside, in my view.  AMAT is a great business. What it achieves (and enables clients to achieve) in making ever more powerful, smaller and energy-efficient chips is akin to magic. If the current EPS is not far from AMAT's true 'mid-cycle' level, then I believe AMAT deserves a multiple that is a lot higher than where the multiple is currently (mid-teens).

The company has not had a single year with negative FCF in the past 20 years (and that includes the dotcom bust as well as the Lehman financial crisis), and the share count has been constantly declining - all a consequence of being levered to the global technological advancement trends as well as being very important to its clients.  As a serial repurchaser with conservative levels of financial leverage, AMAT is uniquely designed to handle prolonged share price swoons or periods of investor apathy - and if investors continue to value semicap companies at low multiples just due to periodic lumpiness in results or fear of anything with China exposure, AMAT will just keep trucking along and repurchasing shares; eventually patient shareholders would be rewarded.

Catalyst

Ongoing pattern of solid financial results

Reduced uncertainty of path in future US/China relations or export controls