September 25, 2017 - 1:20pm EST by
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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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
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.
-Investor day, 9/27/17
-Continued revenue and earnings growth
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.


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