How Applied Materials Remains on Top

Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get bull's-eyes on their backs and are targeted by other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Even if a company continues to dominate its particular field, other changes in technology can shift spending away from its products. Think about how Microsoft still dominates PCs, but it's pressured by sales shifting to mobile devices like smartphones and tablets.

With that in mind, today we're looking at how Applied Materials (Nasdaq: AMAT  ) innovates. Technology companies can innovate either through acquisitions or spending more on research and development. We'll compare Applied Material's spending in these areas to that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, Applied Materials has spent an average of 13% of revenues on R&D. The table below summarizes how Applied Material's R&D expenditure relative to revenues compares to some of the company's closest peers:

Company

2006

2007

2008

2009

2010

LTM

Applied Materials

12.4%

11.7%

13.6%

18.6%

12%

10.4%

Novellus Systems (Nasdaq: NVLS  )

14.7%

https://w1.ciqimg.com/CIQDOTNET/images/financial_singleBlackLine.gif?urwvid=1879213470 15.4% https://w1.ciqimg.com/CIQDOTNET/images/financial_singleBlackLine.gif?urwvid=1879213470 21.7%

23.3%

https://w1.ciqimg.com/CIQDOTNET/images/financial_singleBlackLine.gif?urwvid=1879213470 13% https://w1.ciqimg.com/CIQDOTNET/images/financial_singleBlackLine.gif?urwvid=1879213470 12.2%
KLA-Tencor (Nasdaq: KLAC  )

19%

14.7%

15.4%

23.9%

18.1%

13%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years, while yearly total is for company fiscal years closing in that period.

It might surprise investors to see that Applied Materials "only" spends 13% of its revenues on R&D. After all, few things are more complex than making the equipment that creates chips with billions of transistors measured in nanometers.

Still, the semiconductor equipment industry generally has lower R&D spending than its peers in the telecom equipment field, for example. Applied Materials has been able to keep its absolute R&D spending totally flat over the past five years while growing sales 19%. The end result of these cost reductions is that operating income growth has managed to keep pace with sales growth. Checking in with competitors, Novellus' R&D spike in 2009 was purely the result of shrinking sales. Over the past five years, the company has actually slashed its total R&D spending by 26%.

Acquisitions
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses like hard drives and PCs while it focused on acquiring additional services and software expertise that have transformed its business model.

However, on the opposite end of the spectrum, Hewlett-Packard is often criticized for under-investing in research and development to the point that it has to overpay on acquisitions to catch up with competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow. With that in mind, let's take a look at Applied Material's free cash flow over the last five years against cash spent on acquisitions.

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years, while yearly total is for company fiscal years closing in that period.

As you can see, Applied Materials isn't afraid to buy smaller competitors to gain advanced technology in areas it already is a leader in, or move into new markets. However, the company's biggest splash yet doesn't register on the above graph. That's because Applied Material's recently announced $5 billion acquisition of Varian Semiconductor Equipment (Nasdaq: VSEA  ) has yet to close.

After swallowing up such a large competitor, will Applied Materials -- like Alexander -- have to weep, for there are no more companies to acquire? While the company exhausted its cash balance buying Varian (and will have to now take on debt), I could still see it sneaking some smaller deals in during the coming years. The reason for that is simple: with nearly $1.8 billion in trailing cash flow, Applied Materials should be back at a net cash position within a couple years. After it has shored up its balance sheet, the company's continuing aggression in the solar and LED space could lead to it scooping up some competitors to make it more competitive in these segments.

Final thoughts
If you're looking to stay updated on Applied Materials, or any other companies listed above, make sure to add them to our free watchlist service, My Watchlist. It's free, and it helps you constantly stay updated on news and analysis on your favorite companies.

Eric Bleeker owns shares of no companies listed above. The Motley Fool owns shares of Microsoft, International Business Machines, and Applied Materials. Motley Fool newsletter services have recommended buying shares of Microsoft and creating a diagonal call position in Microsoft. 

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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